NEW YORK (TheStreet) -- Federal Reserve Chair Janet Yellen was in front of Congress again this week. And Congress wants to know what the Fed is going to do.
If you are the chair of the Fed, how do you tell a Congressional panel that you don't know what is going to happen -- or what you are going to do? The fact is that the Fed has never been in a situation like the one it is now facing.
And the situation is tough. The economy is now in its fifth year of recovery, although the recovery has been one of the weakest on record. The labor force participation rate is at its lowest level in the past 40 years, something that will not be turned around by the usual economic stimulus. Bank lending continues to be modest in terms of producing real economic growth. The federal government is at a standstill, given the gridlock in Congress and the fact that the president appears to have entered the lame-duck phase. And the commercial banking system has more that $2.6 trillion in excess reserves sitting on its balance sheet.
It is understandable that everyone wants to know what the Fed is going to do about it.
The Fed has announced that the current round of quantitative easing will end in October. But that just means that the Fed will not be acquiring a certain amount of securities every month on a regular basis.
Will the Fed then begin to raise interest rates?
Yesterday, Yellen told the Senate Banking Committee, "If the labor market continues to improve more quickly than anticipated... then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned."Watch TheStreet's Economics Correspondent Joseph Deaux break down Yellen's Testimony:
So what does that mean?
Well, there are two ways that interest rates can rise: either demand increases or supply declines.
There is next to no demand for federal funds these days. There is little demand for loans, so the commercial banks are not seeking funds to meet market demands for loans. And this year the effective federal funds rate has rested below 10 basis points, reflecting no pressure at all in the market.
In terms of supply, there are $2.6 trillion in excess reserves in the banking system. Is the Fed going to remove reserves from the banking system until the lack of supply becomes sufficient to cause the federal funds rate to rise?
Or are there other means of pushing up the federal funds rate? For example, could the Fed increase bank reserve requirements to reduce "excess" reserves? The Fed did this in 1937 -- with disastrous results.