Fed´s exit strategy

RGE Monitor

The Fed's aggressive monetary easing has led to a sharp rise in money supply. This has sparked concerns of high inflation should the Fed fail to roll back easing once an economic recovery is underway. The Fed may be afraid to tighten monetary policy too early and kill the recovery. In the medium-term, deflationary pressures will most likely outweigh inflationary pressures. But in the longer-term, will the Fed be able to exit from balance sheet expansion in time to avoid breeding high inflation, particularly asset bubbles?

Exit strategies from the Fed's credit crisis intervention programs:
# 1) Wait for demand to wane: Many Fed lending programs extend credit primarily on a short-term basis and thus could be wound down relatively quickly. In addition, since the lending rates in these programs are typically set above the rates that prevail in normal market conditions, borrower demand for these facilities should wane as conditions improve. (Bernanke)
# 2) Reverse repo or sale of securities: The Fed can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities. Of course, for any given level of the federal funds rate, an unwinding of lending facilities or a sale of securities would constitute a de facto tightening of policy, and so would have to be carefully considered in that light by the FOMC. (Bernanke)
# 3) Supplemental financing from Treasury: Some reserves can be soaked up by the Treasury's Supplementary Financing Program. (Bernanke)
# 4) Raise interest rate on reserves: In October of last year, the Federal Reserve received long-sought authority to pay interest on the reserve balances of depository institutions. Raising the interest rate paid on reserves will encourage depository institutions to hold excess reserves with the Fed, rather than lending them into the federal funds market at a rate below the rate paid on reserves. Thus, the interest rate paid on reserves will tend to set a floor on the federal funds rate. (Bernanke, Woodward/Hall)
# 5) Time commitment: The Fed needs to issue a pronouncement to assure the public that there is no need for concern about inflation after the recovery and to reaffirm its historical commitment to stable and low inflation (Woodward/Hall)
# 6) Raise reserve ratio: The Fed could increase liquidity requirements up to the point where excess reserves are fully sterilized. Once this is done, the money supply can be expanded as much as needed to reactivate the economy via open market purchases or by allowing financial institutions controlled access to the rediscount window (Cottani/Cavallo)
# 7) Issue debt: Fed could issue its own bills, as other central banks do. It could rely on a wider variety of investors, not just primary dealers, to manage its balance sheet. It would restrict the maturity of such bills to less than 30 days to avoid interfering with Treasury's longer-dated issuance. The hitch is that Congress has to authorize it (Economist)
# 8) Wait for asset markets to correct themselves: Risky assets - such as commodities, corporate bonds and equities - rallied this year on 'green shoots' but may correct their overshoots when it becomes clear that the economic rebounds around the world were inventory-driven and a recovery in global demand growth has not yet begun

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