AMID another wave of feverish speculation about US interest rates Janet Yellen, chairwoman of the US Federal Reserve, confirmed on Wednesday what most observers suspected: US central bank will not raise the crucial Federal funds rate this month.

But she also suggested that the Fed hopes to act soon, possibly as early as September (assuming, that is, that events in Greece do not create a wider crisis). Little wonder, then, that market traders are now braced for a sticky summer; the Fed has not raised rates for almost a decade.

As investors watch the calendar, they should not lose sight of something else: namely that rate rises are not the only hot issue on the Fed’s agenda right now. Far from it. Behind the scenes, a second argument is under way about how the Fed will unwind the extraordinary technical experiments it has launched since 2008. And, while this second discussion may not appear as thrilling as the speculation about dates, it too could end up being crucial.

There are at least two important issues at stake. The first is the question of what the Fed plans to do with the assets sitting on its balance sheet. Until the onset of the 2008 financial crisis, these totalled about $1tn, mostly in the form of government bonds. The balance sheet has since increased to more than $4tn.

The Fed has indicated that it plans to shrink that bloated balance sheet to a more normal size within a decade. And, when the US central bank does so, it could use this process as a second tactic to raise rates, alongside the usual rise in the Fed funds rate.

After all, if it were to sell the bonds it holds, this would cause prices to fall — and yields to rise (in effect reversing what happened during quantitative easing).

However, Fed officials seem divided on whether this would be a good idea. Most of those at senior level seem very wary of taking this second route since the realm of activist balance sheet management sits in something of an intellectual vacuum.

This is because, although extensive research has been conducted on the link between the Fed funds rate and the real economy, nobody quite knows what might happen if the central bank tried to raise rates by selling assets. So, rather than spook the markets by taking a potentially unpredictable step, most Fed officials would prefer to shrink the balance sheet ‘naturally’, by letting the bonds mature without replacing them.

When future historians write the story of finance in this decade, the current feverish debate about whether rates rise in September or December may appear a mere footnote in the great battle to make the Fed more ‘normal’ again

But the problem is that these assets will not expire smoothly. The Fed’s models suggest that the balance sheet should shrink to a more normal size after seven or eight years. But the projected pattern of decline is jagged; a third of the Treasuries mature in 2018. So one question now subject to fierce debate is whether the Fed will be forced to embrace balance sheet activism just to avoid market shocks.

The second, related, issue is what happens to the funds that private banks have parked as spare reserves at the central bank in recent years. In the five years before the 2008 crisis, these ‘reserves’ were tiny, just $11bn on average each day, partly because the Fed did not pay interest to banks.

But by 2014 the reserve balance had risen to $2.6tn and the Fed pays 25 basis points of interest.

This has in effect introduced what central bankers call a ‘corridor’ policy system: instead of the system revolving around just one rate (that is, the Fed funds), there is now a second rate too. This pattern is not unusual: central banks in places such as the UK or Canada have used a corridor approach for many years. But the Fed has never attempted this before, and officials are still trying to work out the implications.

Take the issue of so-called ‘reverse repurchase agreements’. The Fed recently introduced this tool in the hope of finding innovative ways to shrink the balance sheet. But though some Fed officials think it will help ease the transition, others fear it will undermine the money market fund sector if a wider market panic erupts (with, say, Greece), and do not want to expand it in any way.

Either way, as the debates bubble on, the one thing that is clear is that these seemingly arcane details about financial plumbing can matter deeply. So it is no surprise that Ms Yellen stressed on Wednesday that, if you want to understand monetary policy now, you have to take a long-term view.

When future historians write the story of finance in this decade, the current feverish debate about whether rates rise in September or December may appear a mere footnote in the great battle to make the Fed more ‘normal’ again.

gillian.tett@ft.com

• Published in Dawn, Economic & Business, June 22nd, 2015*

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