What happens when the Fed hikes rates?

Yellen also warned that keeping policy too easy for an extended period of time presents risks to the economy. Photo / Getty

The Federal Reserve is widely expected to raise its benchmark interest rate this week for the first time in nearly a decade, marking the end of the central bank's emergency response to the financial crisis but raising new questions about its next steps.

The Fed dove into uncharted territory in 2008 when it took its target interest rate all the way to zero as the country slid into recession. It experimented with unconventional ways to stimulate the economy, pumping roughly $3.5 trillion into the recovery to boost the flagging economy.

Now, financial markets are all but certain that the Fed is ready to start pulling back. Odds of an increase in in the Fed's target rate when the its top brass meet in Washington this week have topped 80 percent. Fed Chair Janet Yellen said earlier this month that she sees the risks to the Fed's economic outlook as "very close to balanced" -- which many analysts see as code for a rate hike. The Fed is expected to announce it decision on Wednesday afternoon.

"With the meeting now just a few days away, we see very little to derail lift off at this point," Barclays economist Michael Gapen wrote in a client note.

Raising rates, however, is only the first step in getting the economy -- and Fed policy -- back to normal. The process will likely take several years, and there is heated debate over whether the pre-recession standards for a strong economy and appropriate monetary policy are even achievable.

After deciding to increase rates, the first challenge facing the Fed is exactly how to do it. Historically, the central bank has set a target for the federal funds rate -- the amount that banks charge to lend to each other overnight -- and bought and sold Treasury bonds on the open market to hit that goal.

But that method will prove too unwieldy now that the Fed has amassed a balance sheet of more than $4 trillion. Instead, the central bank hopes to manage the fed funds rate by changing two other rates: the interest it pays to banks for reserves held at the Fed and the amount it pays other financial institutions, such as money market funds, for short-term trades known as reverse repurchase agreements. The former is expected to act as a ceiling on the fed funds rate; the latter a floor.

The mechanics are complex, highly technical -- and untested on a broad scale. Still, the Fed has been conducting smaller trials for the past two years and is confident the experiment will work.

Monetary policy implementation is just a means to an end. There is no obvious single 'right' way to do it.

Simon Potter, head of the Fed's open market operations in New York

Once the Fed achieves liftoff, it will have to decide how long to wait before raising rates again. Officials have emphasized that it will move gradually to test the response of financial markets and the economy, both at home and around the world. The Fed's fall forecast showed officials expect to push their benchmark interest rate up to a median of 1.4 percent at the end of next year, implying a quarter-percentage point hike at every other time the central bank meets in 2016.

Investors, however, believe those projections are too optimistic. Financial markets overwhelmingly are betting that the Fed's rate will be below that at the end of next year. Central bank officials have tried to convince the public that they do not plan on stair-step increases, emphasizing that they can move more quickly or more slowly, depending on the progress of the recovery.

There remains the delicate task of guiding expectations for the future path of rates.

But the bar for changing course is unclear. Yellen has said she wants to see confirmation that inflation, which has been running below the central bank's target of 2 percent for several years, is actually picking up. Meanwhile, three other top officials have argued against a rate hike this week and will likely continue to push for concrete evidence of inflation to justify additional rate increases. Others worry the Fed could wind up being overly cautious and not act aggressively enough to rein in an overheating economy.

"There remains the delicate task of guiding expectations for the future path of rates," Millan Mulraine, a deputy chief analyst at TD Securities, wrote in a research note before the meeting. "Managing the message will be central to the Fed's communication effort with the markets."

Even with a gradual pace of increases, the Fed's benchmark rate may not return to its historical long-run average of 4 percent. The Fed's fall projections fell just shy of that goal at a median of 3.5 percent. Some economists believe that the stopping point could be even lower, due to the double whammy of a slowdown in productivity and a shrinking workforce that have lowered the speed limit for the American economy.

The Fed also eventually plans to shrink its balance sheet, but it also may not return to its pre-crisis level. In a strategy outlined last year, the Fed committed to maintaining the size of its balance sheet until after the first rate hike. But exactly how long afterward remains up for debate.

The central bank said it plans to reduce its balance sheet by not replacing assets as they mature, a process known as reinvestment. This month alone, the Fed committed to reinvesting $21 billion. It's likely the Fed will slowly phase out that process, then allow its portfolio to decline naturally. It has explicitly stated that it does not expect to sell its holdings of mortgage-backed securities.