ECON430-Topic #2: Exit Strategies

The Fed has pumped the economy with money during the last year and a half, helping to ease the liquidity crisis that gripped the economy in late 2008. However, the Fed has long discussed their exit strategy from this position. The Fed traditionally would sell off the many assets that they have been holding, but economist James Hamilton notes that a sell off would likely result in higher interest rates and a slower recovery. Hamilton makes many very good points in his blog, particularly that the rise in bank reserves, and the selloff in

IOER has played an increasingly important role in the Fed’s toolkit, and looks to be even more important in the future. I would like you to consider the various exit strategies proposed by economists inside and outside the Federal Reserve. Ben Bernanke has stated the FOMC’s ‘official’ position, but other economists have had other opinions. The KC Fed’s Tom Hoenig has pointed out the problems with the current Fed stance, and is calling for a faster removal of stimulus relative to the Fed’s current official position.

Questions you might try to answer:

  • Consider the proposed exit strategies of the Federal Reserve.
  • What are the possible unintended consequences of the proposed exit strategies.
  • If you have examined another exit strategy, why would it result in an improved outcome over the Fed’s strategy?

27 thoughts on “ECON430-Topic #2: Exit Strategies”

  1. Over the past year, excess reserves have reached alarming heights of over one trillion dollars, increasing the concern for future inflation. So, one of the proposed exit strategies by the Federal Reserve is to raise interest rates on banks’ reserves, thus restraining the money supply. However, this will most likely fail as an anti-inflation tool because of underlying complications. How is the Fed supposed to determine the exact interest rate required to cause the banks to hold onto the trillions of dollars within their reserves? As multifaceted as the U.S. Macroeconomy is, a feat like this is unfeasible. For one, this interest rate has to be desirable over all other interest rates. Not to mention that timing is everything because of the instability of reserves. So, the Fed will have extreme difficulty picking an effective interest rate with the cyclical feature of reserves and the varying private interest rates. As of right now, Ben Bernanke has been ambiguous about the timing of this exit strategy, but even if the Fed continues to gradually increase the interest rate (testing market reactions), they will not avoid the above intricacies. Maybe, the Fed should consider the possibility of implementing several strategies at once instead of cautiously applying them separately.

  2. The Fed has an option to simply sell the assets on its balance sheets and thus reduce the money supply. The problem is, most of its balance sheet is absorbed by the mortgage-backed securities, and a sale of these could drive mortgage rates up (1). This could damage the already fragile housing sector and put additional strain on the economy. Another exit strategy is using the reverse repo agreements, which would drain reserves from banks. A potential drawback is that this method is short-term, and in some cases the agreement is set up for repurchasing securities overnight. I’m not sure how this could prevent banks from lending the reserves if the money is returned fairly quickly. Another drawback is the uncertainty present in having multiple counterparties participating, as opposed to “primary dealers” the Fed ordinarily exclusively deals with (2). This program needs to be large-scale and drain hundreds of billions of dollars of reserves in order to be effective, and it is doubtful whether the operation can have the required scope. With IOER, a possible drawback could be social and political backlash, which could cause unrest (3). Using taxpayers’ money to essentially pay banks for not lending money seems like a PR nightmare given the state of the economy and the current negative view of the banking system.

    1) http://www.washingtonpost.com/wp-dyn/content/article/2010/02/10/AR2010021001254_2.html

    2) http://www.reuters.com/article/idUSTRE5B63EA20091207

    3) http://seekingalpha.com/article/162416-fed-exit-strategy-can-stocks-survive-the-bailout-party-hangover

  3. Although Ben Bernanke has outlined three main exit strategies, many economists seriously doubt their efficiency (1,2,3) The main counterargument is that all these strategies are unable to stop inflationary processes. However, some argue, that there is a sound alternative to ‘fed’s exit strategies’. The main idea of this alternative is to authorize FED to issue FED Debt Securities (4). Although it is an unprecedented strategy, it has a number of advantages over “conventional fed’s choices”: 1) Unlike US Treasury Debt, Fed’ Debt Securities (advisably Long-term e.g. 10 yrs, 20 yrs) would not be added towards the US government debt (although Fed debt would be backed up by US government) 2) The key to success of these Debt securities is their liquidity, to be more precise, they must be less liquid than cash and US Treasuries. To increase their effectiveness, Fed can mandate banks to hold up to a certain amount in these securities and also make these securities available only to banks-members of FED’s Reserve System. Alternatively, these securities could be made non-tradable, which would ultimately decrease their liquidity. If banks would be mandated to buy these debt securities up to a certain amount, Fed’s policy would succeed in effectively reducing the liquidity held in banks’ excess reserves.

    1. http://krugman.blogs.nytimes.com/2009/11/25/no-exit
    2. http://moneymorning.com/2009/07/30/bernankes-exit-strategy-2
    3. http://moneymorning.com/2009/08/04/exit-strategy-stagflation
    4. http://blogs.reuters.com/great-debate/2009/03/26/fed-sets-out-exit-strategy

  4. It seems to me that the exit strategies proposed by the Fed are counter productive to President Obama’s job stimulus that he recently highlighted in early December. Among other things, the President wants to “increase lending to small businesses by utilizing the Troubled Asset Relief Program” because small business’s typically have the hardest time obtaining credit (1). Meanwhile, the Fed is considering raising interest rates and switching to the IOER in an effort to gain more control of possible inflation problems (2). In essence, the Fed would be reducing the supply of credit by encouraging banks (through a higher interest rate) to keep their money in the form of excess reserves. This exit strategy would undoubtedly pose credit problems for small business, which the President is trying to improve upon. I cannot begin to estimate the magnitude of changes in the supply of credit (by President Obama’s plan) and reduction in credit (by the Fed’s exit strategy), but it’s clear that the Fed’s decision would weaken the efforts of President Obama’s job stimulus plan. Although the Fed needs to develop an appropriate exit strategy, they need to be aware of unintended consequences similar to the one described above.

    (1) http://online.wsj.com/article/SB126028857157682051.html
    (2) http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm

  5. There are various opinions on the matter of how to relinquish our trillion dollar deficit into “exit strategies”. These articles bring up many important points about selling off the mortgage-backed securities, raising the Fed Funds Rate, and the idea of “reverse repos”. However, “despite Bernanke’s recent press release […] the Fed has not offered anything substantially new” (1). But does this really matter? The timing of such an important decision may be more crucial than the decision itself. With such a high amount in excess reserves and the threat of inflation in the near future it is evident a decision is needed to solve this. However, some believe “we’ve got a long way to go before the economy begins to grow again in any substantive sort of way” (2). Bernanke has also stated in his press release that “no decision has been made on this issue; we will be guided in part by the evolution of the federal funds market”. Even if no “exit strategies” have been implemented, I hope this press release will help build confidence in the Fed to create one.
    (1)http://www.marketrap.com/article/view_article/91199/fed-exit-strategy-preparing-for-inflation-spdr-gold-trust-et-al-part-2
    (2)http://www.marketoracle.co.uk/index.php?name=News&file=article&sid=17346

  6. Hamilton was curious as to the Fed’s comments about their unwinding policy consisting of apparently holding MBS’ to maturity while raising the IOER. To him, holding the MBS’ was expansionary policy, while raising the IOER was contractionary policy giving the banks an incentive to keep reserves with the Fed to halt inflation. Specifically, Hamilton sights Bernanke’s comments that “currently [Bernanke] does not anticipate that the Fed will sell any of their securities in the short term.” (1) One must read through FedSpeak however, because immediately preceding that quote in Bernanke’s statement, the Fed chief obviously leaves selling of securities on the table, and comments later that he expects such sales would only occur after “tightening policy has gotten under way.” I would disagree with Hamilton and argue that the Fed has no intention of waiting until the assets (specifically MBS) on their books mature.

    To show what a simultaneous raising of the IOER and the selling of assets would look like, Economist Mark Thoma of the University or Oregon posted a model of the demand for reserves(2). Without explaining the model from the labeling of the axes on, Thoma (borrowing a model from a Mishkin book) describes the process whereby increasing the IOER would have immediate effects on Fed’s control over the Fed Funds rate. By raising the floor of the demand schedule for reserves (through an increase in IOER), the Fed would simultaneously be raising the floor on short term rates. He argues that the Fed has expanded the supply of excess reserves to the point that traditional open market transactions would not allow the Fed to sell off assets quickly enough to have their desired control of short-term interest rates, it is a liquidity trap. Alternatively, if the Fed raised the rate on the IOER (this would be the tightening policy preceding sales Bernanke referred to), while scaling back assets on their books at a controlled pace, allowing the market participants to adjust, eventually the Fed would have shrunk the excess reserves to the point where traditional open market transactions were practical again. Further, the raising of the IOER gives the bank’s further incentive to not lend the excess reserves, helping to control inflationary pressures until those reserves can be scaled back in other ways.

    (1) http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm
    (2) http://moneywatch.bnet.com/economic-news/blog/maximum-utility/the-feds-exit-strategy/455/

  7. One alternative to the Fed’s exit strategy is the large scale reverse repurchase agreements, or repo agreements. In the repo agreements the Fed sells an asset to a financial institution and agrees to buy it back in future at a slightly higher price. The buyer pays cash for the asset and that is only repaid when the Fed buys the asset back. The cash is therefore out of the system for the duration of the reverse repos maturity. The Fed can roll these reverse repos over and thus continue to drain excess reserves on a staggered basis, until all assets like agency mortgage-backed securities have matured. (1) The central bank will be able to conduct reverse repos using mortgage-backed securities as collateral and would soon after be able to conduct them with a broader set of counterparties. (2) Unlike asset sales, reverse repos would not necessarily reduce the size of the balance sheet or extinguish reserves on a permanent basis. But as a practical matter, the Fed could continuously roll over the reverse repos until the underlying asset matures, thereby effectively making a permanent reserve drain. (3) However, some officials believe the Fed will not have to resort to large reverse repos or asset sales, arguing that its ability to pay interest on excess reserves will control the federal funds rate and also enable the Fed to keep banks from lending the reserves into the economy if necessary.

    (1) https://www.ubs.com/1/e/bank_for_banks/news/topical_stories/edition_2.html
    (2) http://uk.finance.yahoo.com/news/factbox-fed-s-exit-strategy-toolkit-reuters_molt-cabb3d660937.html?x=0
    (3) http://acrossthecurve.com/?p=10040

  8. This idea that the FED is looking to stop the increase in the money supply by paying interest on banks’ excess reserves has been propagated by the media, but it seems that the FED itself is not too interested in cutting borrowing by raising interest rates (1). At least not yet, as the economy is still slowly recovering and consumers are not confident in the stability of the market (2). By changing its policy tools, the FED does more to confuse consumers than anything else. The point here is that if the FED does not intend to contract the money supply, then it should not look for another tool to control it. The FED should allow the banks’ excess reserves to flood the market (yes, we would deal with some inflation, which is great for borrowers), allow for the restructuring of the financial markets, especially in regards to the upcoming changes in banking regulation, and continue to use its usual instruments to control the federal funds rate. It is up to the market to better allocate resources, and the recent policies used by the government have done enough damage.
    (1): http://online.wsj.com/article/SB10001424052748703315004575073030122957918.html?KEYWORDS=fed+exit+strategy+inflation
    (2): http://news.moneycentral.msn.com/provider/providerarticle.aspx?feed=AP&date=20100222&id=11138602

  9. Previous comments have noted that the real risk of future inflation when the Fed tries to releases the excess reserves on its balance sheet. This article, from the Heritage Foundation, discusses all of the exit strategies that have been discussed by prior comments (1). One point that is brought up is that the timing of the release of excess reverses into the economy is a very important. In theory, sluggish economic activity and high unemployment should dampen inflationary pressures according to the Philips Curve. However, in the 1970s, the economy experienced persistent high unemployment and high inflation. The concern is that the slowed economy will not provide a buffer against inflation if the Fed’s exit strategies are not properly timed. Conceivably, if The Fed’s perception is off base, the economy could experience not only high unemployment but high inflation.

    (1) http://www.heritage.org/Research/Economy/bg2371.cfm

  10. As the global economy continues to recover, several major central banks around the world have already begun hiking up their rates, such as the Reserve Bank of Australia and Norway’s Norge Bank (1). While the United States’ Fed and the European Central Bank have made a lot of noise about moving forward and retracting the major stimulus plans, they are reluctant to move interest rates due to the shock that would occur from any rapid selling assets or any sudden movements in rates. The speculation alone of the increase in the Fed Fund’s Rate, along with the recent increase in the discount rate has already caused a shock to the United States Futures market (2). Therefore, the exit tools that have been put into place seem like a reasonable way to unload the assets the Fed has, while avoiding a shock to the markets. As the economy rebounds, the extended period of stimulus easing will allow the Fed asset holdings to decrease while the market increases, avoiding shocks and returning liquidity to the economy. Proponents of quick action like Thomas Hoenig may resent the slow moving exit strategy, but too much movement and intervention may be more harmful than motivating.

    (1) http://online.wsj.com/article/SB10001424052748704454304575081881624162818.html?mod=WSJ_latestheadlines
    (2) http://online.wsj.com/article/BT-CO-20100217-714367.html?mod=rss_Bonds

  11. I completely agree with Federal Reserve Bank of Kansas City President Thomas Hoenig. The Federal Reserve needs to take that “difficult step” and sell off all these mortgage backed securities and other troubled assets soon. Today, in my international finance/economics class we were talking about this. The government stepped in with quantitative easing to stop what may have been a depression (1). However, the government may have stopped the depression but they also delayed some of the economic pain. Professor Elwood compared it to a band-aid, he said you can either just rip it off and deal with the quick pain or tear it off slowly and have it hurt a little for a long time (what we are doing now). The stimulus artificially propped up the economy and now that it is starting to go away economic pains are starting to show. American new home sales are declining after the initial end of the buyer’s tax credit and the MSCI World Index fell by 4.2% in the month after doing well in parts of 2009 (1). To go along with Thomas Hoenig, a study was done by Antonio Afonso of the European Central Bank and Davide Furceri of the University of Palermo which concluded that for every one-percentage-point rise in government spending as a proportion of GDP, the growth rate falls by 0.12-0.13 percentage points (1). So these deficits are hurting our economic growth. Lets just tear off the band-aid suffer the pain and evidentially ,probably more quickly then we think everything will get back to normal.

    (1) “Stimulating Debate” The Economist, 2/6/2010
    http://www.economist.com/businessfinance/displaystory.cfm?story_id=15453057

  12. I believe that a mix of the several strategies will be the most effective tool in lowering inflationary pressures. Just as people try to diversify their risk within their portfolios, implementing a number of approaches to drain the excess reserves from the system may stop negative consequences from a single policy. With the FED testing different tools slowly, the market would have time to adjust and become familiar with the operation. The usual instruments of the discount rate and FFR can be made more effective with the so called” corridor system.” The discount rate is always higher than the FFR, and the ability for banks to borrow at the discount rate stops upward spikes of the FFR. The new tool of IOER, if kept lower than the FFR, will stop downward plunges of the federal funds rate. The FFR is the main instrument used to control the amount of money within the banking system and a stable FFR would ensure stability within the market. Reverse repos, term deposits, and selling MBS can all pull money out of circulation and I would again say that implementing each of these instruments on a small scale would be best to decrease risks.

    http://www.ft.com/cms/s/0/2872539a-1bee-11df-a5e1-00144feab49a,s01=1.html

    http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html

  13. The Fed has outlined its proposed exit strategies and critics have pointed out flaws and also proposed their own strategies. In the end, however, it needs to be acknowledged that the Fed is in a less-than-optimal situation where they could be forced to choose the “lesser of two evils”. Over the long-term, the Fed has two goals in mind: 1) Promote growth that will decrease unemployment, and 2) keep inflation under control. While the Fed will attempt to achieve both goals through the policies listed in the articles above, it is not likely that both can be achieved.

    The “lesser of two evils” would then be whether to promote growth at the expense of inflation or to keep inflation low while not solving the unemployment issue. James Kostohryz argues that the Fed will choose an “inflation bias” due to political pressure and other reasons. (1) If this is the case, he points out that the Fed must continue its “double speak” in an effort to keep inflationary expectations low.

    If the Fed is successful in keeping inflationary fears at a minimum, they may be able to stop inflation from becoming an issue. However, this is a long shot. Harvard economics Professor Martin Feldstein says that inflation will be a danger due to the Fed currently holding illiquid assets that will be difficult to sell. (2) The combination of the poor economic position and the illiquid assets may be too much for the Fed to overcome.

    In conclusion, the Fed has no “optimal solution” and many of the critics’ solutions would have similar drawbacks. Due to political pressures, fear of recession, and the method the Fed conducted its monetary policy, the “best” solution may be to choose the “lesser of two evils.” However, it can be argued that the dilemma currently faced by the Fed is heavily preferred to the economic collapse that was possible if no stimulus had taken place during the height of the crisis.

    1: http://www.minyanville.com/businessmarkets/articles/fed-exit-strategy-inflation-bias/2/23/2010/id/26961?page=1

    2:http://www.bloomberg.com/apps/news?pid=20601110&sid=aGAGdAyBd6dY

  14. I found one of James Hamilton’s points particularly interesting. He notes an apparent inconsistency in Bernanke’s exit strategy. The mortgage-backed securities are being held in an effort to keep money in the economy and stimulate it (Hamilton). Selling of these securities may result in a monetary contraction and a rise in interest rates (Hamilton). However at the same time the Federal Reserve is paying interest rates on reserves kept at the federal bank (Hamilton). This in itself is causing a monetary contraction.
    I wonder if any strategies could be employed where the MBS’ were sold of at a slow rate. Any monetary contractions could be observed and closely monitored. Because the Fed controls the interest rate it pays on reserves it could lower that interest rate to pump money back into the system. This process could be done slowly so that the reduction in interest rate could account for or counter act monetary contractions due to the selling of MBS’.
    Any thoughts on this as one of the components of an exit strategy?

  15. According to Bernanke’s Federal Reserve’s exit strategy, “to help manage the crisis on the economy, the Federal Reserve established a number of temporary lending programs.” One of his main points is that “The Federal Reserve has borne no loss on these operations thus far and anticipates no loss in the future.” I feel is was unquestionably helpful for the government to take on these debts in the short term while these financial institutions got themselves back on their feet. The question I ask is whether these programs were the most beneficial in shoring up these institutions balance sheets away from insolvency. All the while these temporary lending programs where going on, the government was also paying off interest on the mass reserves that these financial institutions held on reserve at the Fed. I have a sneaking suspicion that the accumulation of the interest on these reserves had more to do with improving the balance sheets of these financial institutions long-term then any of these lending programs. And if this is the case would it not be misleading to say that we are doing all this without a loss since: a). we have only just started paying off interest on excess reserves since this crisis began and b). these interest payments have no origin other then to have to come out of taxpayer money since the reserves are doing nothing other then sitting there not invested.

    Bernanke, Ben S. http://Www.federalreserve.gov. Proc. of Committee on Financial Services, U.S. House of Representatives, Washington D.C. Federal Reserve, 10 Feb. 2010. Web. 23 Feb. 2010.
    .

  16. Flooding the market with over a trillion dollars isn’t going to lead to all positive outcomes; this is the reality the Fed is facing now when trying to find an exit strategy and somehow reduce the money supply. They are desperately trying to find a good exit strategy as unemployment is expected to continue staying high although it did drop to under 10% for the month of January. There are several different exit strategies that could be feasible. “Interest on reserves is the workhorse . . . and is intended to be the main tool” in the Fed’s exit strategy, James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview Monday. (2) This is contrary to the older regimes that were always revolving around the Federal funds rate. Other ways to deal with the huge outpouring of money into the money supply are being experimented by the Federal Reserve Bank of New York which controls the central bank’s monetary policy by buying and selling securities, is attempting to drain the money supply using tools called “term deposits.” (1) These would basically give banks incentives to deposit money at the Fed for a given period of time. Furthermore, the Fed is also resting “reverse repurchase agreements” which would let the central bank temporarily swap assets on its balance sheets for cash, the end result of course being to pull money out of the financial system. These all come with pros and cons however. Many previous bloggers have stated that the inevitable rise of inflation is the main problem with these exit strategies. By reducing the money supply, as previously stated, this is a main weapon in fighting this said inflation. Another way to combat this inflation is to decrease the amount of unconventional lending programs that the Fed began experimenting with during the peak of this financial crisis. Fed leaders claim they will stop purchases of $1.25 trillion in mortgage-backed securities by the end of March, and they may even begin selling some of these on the open market instead of letting them reach maturity over a lengthy amount of time. The advantage of doing this would be, again, pulling money out of the economy and shrinking the Fed’s massive balance sheet, thus reducing inflation. However, unsurprisingly, there are consequences to this exit strategy as well. This process would most likely drive up mortgage rates (by selling off these subsidized mortgaged assets) which would in turn hurt the housing sector that has already had so much trouble attempting to recover. (2) It appears there isn’t yet a clear method of exit strategy the Fed has devised without very apparent negative effects, which isn’t all that shocking. The economy is fragile, and the Fed is has been, and is talking about continuing, to bend it in very extreme methods. We should all sincerely hope that they don’t bend it too much so that it breaks.

    (1( http://www.federalreserve.gov/newsevents/press/monetary/20091228a.htm

    (2) http://blogs.wsj.com/economics/2009/09/16/fed-paying-interest-on-reserves-a-primer/tab/article/

  17. On exit strategy, I think that interest on reserves gives the Fed the necessary tool it needs to raise private-sector borrowing rates even in the presence of substantial excess reserves. And excess reserves are likely to remain substantial for a while, because selling its bond holdings back into the market could be quite disruptive, it seems to prefer to hold them to maturity. To soak up reserves, it could of course use reverse repo but it’s unclear to accommodate reverses of the size needed to make in excess reserves.

    The ideal method would be the ability to issue “Fed bills”. They would not be subject to the debt ceiling, and could enable the Fed to spread its liabilities across a much larger universe of counterparties (eg, money-market mutual funds) than just the primary dealers.

  18. It appears that the U.S. Treasury Department is already taking action to drain reserves balances from depository institutions. On February 24th the Treasury plans to increase its program for selling bills on behalf of the Federal Reserve to $200 billion over the next few months. (Christie, 2010) Normally the Treasury auctions off $5 billion a week, now they will auction off $25 billion in 56-day bills. The bills will be part of Supplementary Financing Program which President Obama just increased from $12.4 trillion to $14.3 trillion. The effect of these treasury bills is to drain the reserve balances from depository institutions. This marks one of the first steps in lowering the massive reserve accounts that the banks have built up, and lowers the monetary base (tighten monetary policy). This decision was developed in consultation with the Fed, the Treasury said. The next step I would expect the Fed to make would most likely be using large scale reverse repurchase agreements to help further reign in the reserve balances. This would help to further reduce excess liquidity. (Staff, 2010)

    Works Cited
    Christie, R. (2010, 2 23). Treasury to Raise SFP to $200 Billion Over Two Months (Update2). Retrieved 2 23, 2010, from Bloomberg.com: http://www.businessweek.com/news/2010-02-23/treasury-to-raise-sfp-to-200-billion-over-two-months-update2-.html
    Staff. (2010, 2 19). Factbbox: Fed’s Exit Strategy Toolkit. Retrieved 2 23, 2010, from The Post Chronicle: http://www.postchronicle.com/news/business/article_212285568.shtml

  19. The FED has recently raised interest on excess reserves to the banks as an incentive to keep the banks from lending, this would help decrease the supply of money by keeping it out of the money market. Another tool would to help the control the financial situation is the reverse repo, where the FED sells securities to the banks that are sold back at a later date to help drain the amount of reserves in the banks. The FED cannot just buy bad assets from the banks because this will cause interest rates to go up which will lead the housing market to fall again. Using these tools, as well as others, IMF chief economist suggests that these tools would have a better chance at having more control of the crisis if the FED aimed at a higher target interest rate. Along with monetary policies, Blanchard believes that it is also necessary to combine these policies with regulatory tools. The FED will try these tools out and see how the economy reacts. It is important that these tools are used at the appropriate time to help the FED get out of this mess.
    http://seekingalpha.com/article/187904-bernanke-s-exit-strategy
    http://news.yahoo.com/s/afp/20100212/bs_afp/financeeconomyimfinflation_20100212174831

  20. Out of the Federal Reserve’s proposed strategies for reducing the money supply, “reverse repos” seem like they could prove effective. While increasing the federal fund’s rate and bank’s reserve requirements will tighten the money supply the consequential drying of credit could prove disastrous given the current economic state. Reverse repo’s entail the swapping of securities off of the Federal Reserves balance sheet for cash (reducing the money supply), under the agreement to buy back the asset at a later time. This will allow grant the Fed additional time for the value of the assets to rise, the contraction of the money supply (offsetting strong inflation), and will not flood the market with mortgages
    (which would causing housing prices to fall further). This strategy has been tested by the New York Federal Reserve to help retract over 180 million dollars. While specific measures of the reverse repos are still being tested, the New York Fed has stated, “The operations have been designed to have no material impact on the availability of reserves or on market rates.” (Reuters). A potential problem of using this method is if asset prices continue to fall, and the Fed has agreed to purchase them back at a higher price the situation between the Fed and the “repo-ed” banks could get messy. However, ideally the Federal Reserve would not buy the assets back until they price has significantly recovered.

  21. On February 10, Fed outlined its exit strategy plans. According to the testimony released on the Federal Reserve website, the reserve draining tools include increasing interest payment on excess reserves, reverse repo, term deposits, and selling securities. I think there are not much policy tool options for Fed, and the plans are adequate. I think it will be all about timing. In fact, I think it would be happening soon because Fed increased the discount rate to 0.75% from 0.5% (http://www.latimes.com/business/la-fi-fed-rate-hike19-2010feb19,0,1158958.story). Although Bernanke insisted this action was not a monetary policy tightening (http://moneymorning.com/2010/02/22/discount-rate-increase/), I think this is a clear sign of the Fed’s view that the economy is recovering, and to prevent a high rate of inflation on the way to recovery, the Fed will take actions soon.

    In current situation, I think increasing interest payment on excess reserves instead of increasing federal funds rate is a right decision. Increasing federal funds rate will give the commercial banks incentives to lend out their excess reserves. As there currently are an enormous amount of excess reserves, if the banks lend out the excess reserves, increased supply of public loan will put downward pressure on the interest rate, and therefore, federal funds rate increase would not be effective. Moreover, M1 will be increased even more. Thus, I think the interest rate on excess reserves is a good alternative instrument for now. With the interest on excess reserve tool, the Fed may use reverse repo and term deposits, so that they could control the market liquidity effectively. It may take long, but by utilizing the tools, I think the Fed would be able to increase the market interest rate and FFR gradually.

    Another tool the Fed mentioned was selling securities. However, the most of the Fed assets are Mortgage Backed Securities, and the Fed is facing a dilemma with their MBS. The Fed purchased MBS to provide liquidity to the market during the financial crisis, and its holding of MBS exceeded 1 trillion now (http://www.reuters.com/article/idUSNYS00777920100218). And many economists and even Fed officials agrees that the Fed should sell its MBS (http://www.businessweek.com/news/2010-02-17/plosser-says-fed-should-sell-mbs-as-growth-picks-up-update2-.html). But the Fed is kind of stuck with these assets because selling the MBS’s will cause the mortgage interest rate to rise greatly and stress the housing market. Again, it will be all about timing.

  22. According to the testimony released on the Federal Reserve website, the reserve draining tools include increasing interest payment on excess reserves, reverse repo, term deposits, and selling securities. I think there are not much policy tool options for Fed, and the plans are adequate. I think it will be all about timing. In fact, I think it would be happening soon because Fed increased the discount rate to 0.75% from 0.5% (http://www.latimes.com/business/la-fi-fed-rate-hike19-2010feb19,0,1158958.story). Although Bernanke insisted this action was not a monetary policy tightening (http://moneymorning.com/2010/02/22/discount-rate-increase/), I think this is a clear sign of the Fed’s view that the economy is recovering, and to prevent a high rate of inflation on the way to recovery, the Fed will take actions soon.

    In current situation, I think increasing interest payment on excess reserves instead of increasing federal funds rate is a right decision. Increasing federal funds rate will give the commercial banks incentives to lend out their excess reserves. As there currently are an enormous amount of excess reserves, if the banks lend out the excess reserves, increased supply of public loan will put downward pressure on the interest rate, and therefore, federal funds rate increase would not be effective. Moreover, M1 will be increased even more. Thus, I think the interest rate on excess reserves is a good alternative instrument for now. With the interest on excess reserve tool, the Fed may use reverse repo and term deposits, so that they could control the market liquidity effectively. It may take long, but by utilizing the tools, I think the Fed would be able to increase the market interest rate and FFR gradually.

    Another tool the Fed mentioned was selling securities. However, the most of the Fed assets are Mortgage Backed Securities, and the Fed is facing a dilemma with their MBS. The Fed purchased MBS to provide liquidity to the market during the financial crisis, and its holding of MBS exceeded 1 trillion now (http://www.reuters.com/article/idUSNYS00777920100218). And many economists and even Fed officials agrees that the Fed should sell its MBS (http://www.businessweek.com/news/2010-02-17/plosser-says-fed-should-sell-mbs-as-growth-picks-up-update2-.html). But the Fed is kind of stuck with these assets because selling the MBS’s will cause the mortgage interest rate to rise greatly and stress the housing market. Again, it will be all about timing.

  23. On February 10, Fed outlined its exit strategy plans. According to the testimony released on the Federal Reserve website, the reserve draining tools include increasing interest payment on excess reserves, reverse repo, term deposits, and selling securities. I think there are not much policy tool options for Fed, and the plans are adequate. I think it will be all about timing. In fact, I think it would be happening soon because Fed increased the discount rate to 0.75% from 0.5%. Although Bernanke insisted this action was not a monetary policy tightening, I think this is a clear sign of the Fed’s view that the economy is recovering, and to prevent a high rate of inflation on the way to recovery, the Fed will take actions soon.

    In current situation, I think increasing interest payment on excess reserves instead of increasing federal funds rate is a right decision. Increasing federal funds rate will give the commercial banks incentives to lend out their excess reserves. As there currently are an enormous amount of excess reserves, if the banks lend out the excess reserves, increased supply of public loan will put downward pressure on the interest rate, and therefore, federal funds rate increase would not be effective. Moreover, M1 will be increased even more. Thus, I think the interest rate on excess reserves is a good alternative instrument for now. With the interest on excess reserve tool, the Fed may use reverse repo and term deposits, so that they could control the market liquidity effectively. It may take long, but by utilizing the tools, I think the Fed would be able to increase the market interest rate and FFR gradually.

    Another tool the Fed mentioned was selling securities. However, the most of the Fed assets are Mortgage Backed Securities, and the Fed is facing a dilemma with their MBS. The Fed purchased MBS to provide liquidity to the market during the financial crisis, and its holding of MBS exceeded 1 trillion now. And many economists and even Fed officials agrees that the Fed should sell its MBS. But the Fed is kind of stuck with these assets because selling the MBS’s will cause the mortgage interest rate to rise greatly and stress the housing market. Again, it will be all about timing.

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