Fed Still Lacks 'Exit Strategy,' but Talks Are Heating Up

Federal Reserve officials held intense talks about exit strategies at their last meeting, with policymakers divided over whether to sell billions of dollars of assets first or simply raise interest rates, according to people familiar with the matter.

Senate Committee on Banking Housing and Urban Affairs hearing during which Federal Reserve Board Chairman Ben Bernanke delivers second semi-annual report on monetary policy.
Senate Committee on Banking Housing and Urban Affairs hearing during which Federal Reserve Board Chairman Ben Bernanke delivers second semi-annual report on monetary policy.

These people suggested the discussion was more robust than described by Fed Chairman Ben Bernanke at the historic news conference that followed the April 27 meeting.

The chairman said the committee "continued its ongoing discussion of the available tools for removing policy accommodation…”

But one source said the Federal Open Market Committee, which was presented with a variety of options by Fed staff members, had not had such a pointed discussion on exit strategies in about a year.

That was when the Fed was on the verge of tightening, a policy move that was reversed as the economy weakened and, ultimately, a second quantitative easing strategy was launched.

To be sure, reporters did not ask the Fed chairman about the exit strategy discussion.

No decisions were made at last week’s meeting on either the timing or form of the exit, but a consensus did develop that ending the reinvestment policy would be among the first tightening measures from the Fed.

Under current policy, the Fed has pledged to maintain the size of its balance sheet by purchasing additional securities with the proceeds from instruments that are either pre-paid or mature.

The policy is seen as maintaining an easy monetary policy stance since it would keep the size of the Fed’s balance sheet unchanged at nearly 3.5 times its size from before the financial crisis.

Letting the balance sheet shrink through a natural roll-off of securities, which would reduce the amount of excess reserves in the banking system, would amount to a tightening of policy.

Bernanke revealed at his new conference the general agreement about allowing reinvestment policy to be one of the earliest exit strategy steps.

“At some point, presumably early in our exit process, we will, I suspect, based on conversations we've been having around the FOMC table, it's very likely that an early step would be to stop reinvesting all or part of the securities which are coming — which are maturing,” Bernanke said.

Yet, a new development appears to be a lack of consensus over the next steps.

A year ago, the FOMC seemed to be in agreement that the committee would raise interest rates first and then sell assets. But several sources said that consensus no longer existed, with some actually favoring early asset sales.

One source questioned whether the Fed could actually set the federal funds target with $1.5 trillion of outstanding excess reserves sloshing around the financial system.

The Fed could be forced to conduct massive draining operations to maintain its target rate, and could find the job easier if it first sold assets and then raised the target rate.

Another source emphasized that no decision had been made but agreed last year’s consensus no longer existed.

“Everything is on the table,” the person said. That could mean asset sales first, or interest rates first, or even both at the same time.

One concern: Doing both could confuse the markets about policy.

Ultimately, the Fed has decisions to make in four critical areas: the language of its policy statement, its reinvestment policies, interest rates and asset sales.

All four could combine in a tightening strategy in some form.