Control of interest rates is the main conventional weapon in the armoury of any central bank. Raising interest rates is seen as a mechanism to dampen the markets and choke off inflationary pressure by driving up the cost of borrowing. Conversely, cutting interest rates is intended to boost economic activity and help the economy out of a recessionary cycle. If interest rates are very low, the central bank will have no conventional weapons to use against slowing economic output and must resort to unconventional tools such as quantitative easing (the electronic creation of cash) which have the potential to go spectacularly wrong.
The Federal Reserve embarked upon the slow process of edging interest rates back up from their historic low value of 0.25% where they had been since December 2008 in December 2015. The Fed has just announced that interest rates will rise by a further increment of 0.25%, the second such rise this year. This puts US interest rates in the band from 1 to 1.25% currently. The range is still vastly lower than the long-term average value of 5.79% (from 1971 to date; maximum 20% (March 1980), minimum 0.25% (December 2008)), so further rises will be on the cards as and when US economic data warrant it.
As a consequence of the Fed’s QE endeavours, it has a portfolio worth an estimated $4.2 trillion which it must disburse (eventually). The Fed announced that it will start the process later this year, but it must be gradual or the bottom would be forced out of the bond markets with a glut of sell orders. In principle, the money created electronically by QE will be withdrawn over time.
QE is dangerous because cash is created without any underlying assets: I have more money because I say I have more money. In a fiat money system the integrity of the currency relies in confidence that the issuing nation state is “good for it”, in essence. Should this confidence be lost, the ramifications for the global financial system would be immense – currencies might become as worthless as the Zimbabwean Dollar.