Goldman Sachs (NYSE:GS) Has Contrary View on Federal Reserve Priorities

There are two major priorities the Federal Reserve is facing, and how they enact deal with them will have a lot of impact on business and consumers. Goldman Sachs (NYSE:GS) has the view that the Fed will increase interest rates rather than unload assets off its balance sheet.

This is contrary to most economists, who believe the Fed will move the assets off their balance sheet first before starting the interest rate increases.

After hearing the testimony of Federal Reserve Chairman Ben Bernanke last week, most concluded the interest rate hike was at the forefront of his tightening strategy, as his focus will be on interest on reserves rather than on the overnight fed funds rate. Bernanke added that the Fed may also set targets for the levels of bank reserves as well.

Most economists, and central bankers, based on what they have been saying lately, believe the central bank will get rid of the assets before implementing higher interest rates. The major reason for that conclusion by most is the time it will take to decrease the $2 trillion-plus currently on the balanced sheet. Starting with interest rates in their view, because of that, wouldn’t make sense.

What Goldman Sachs maintains is the ability for the Federal Reserve to now pay interest on the reserves of banks held there, that gives them more control than in the past over the liquidity in the financial system.

The claim is this keeps the reserves from becoming inflationary because while the technically are liquid, they aren’t putting that money to use in the general economy, which of course would at that time cause inflationary pressures to rise.

In other words, the banks can make money and still be liquid, while holding back from making loans that would be more risky, but also would generate inflation.

This can’t continue on forever, and once the money is started to be loaned again, inflation will surely follow.

Goldman economist Ed McKelvey recently said this in a note to clients, “In the absence of either significant inflation expectations – on the part of consumers as well as traders – or a sudden increase in bank lending, we think the FOMC should resist pressures to drain reserves in significant volumes.”

Goldman thinks it is just as good to tighten policy through interest rates being increased as it would be in removing assets off the books, as it would do the same thing in their view, although admittedly in some cases it would only be a temporary removal, although when securities would be sold by the Fed it would be a permanent event.

According to Goldman, the interest on reserves would more than likely manage the possibility of inflation emerging from the balance sheets, again, making the draining of assets less important as the first measure to be taken.