1. The Problem

2. Exit Strategies An exit strategy will remove or neutralize the enormous volume of excess reserves. Minutes of the Federal Open Market Committee (the policy making unit within the Federal Reserve) suggest the following strategies:

3. (1) Stop (or slow) reinvestment of payoffs to the bonds in its portfolio. This allows a gradual reduction in the size of the portfolio. (2) Modify “forward guidance” on the path for the federal funds interest rate; initiate temporary reserve-draining operations. – a. Reverse repurchase agreements. – b. Issue term deposits to financial institutions similar to CDs these institutions offer their customers.

4. (3) Begin raising the fed funds rate target, supported by management of the interest rate paid on reserves, including excess reserves. – Bernanke, 2010 Congressional testimony: “By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve banks.”

5. Later, in same testimony, Bernanke said: “the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as … the interest rate paid on reserves.”

6. (4) Begin selling agency securities from its portfolio, with sales occurring in a “relatively gradual and steady” manner. Eliminate such securities from portfolio over 3 – 5 years. – In principle, these are less liquid than Treasurys, so the price and interest rate movements may be relatively large. As rates rise with the sales, the risk is restraining economic growth, including the values of portfolios of banks that hold the agency debt.

7. Risks (1) We have little or no experience with most of these actions. What is the right timing of each action? What is the right magnitude? (2) How much do mistakes in timing and magnitude cost the Fed in terms of credibility? In terms of volatility in the economy, including output and inflation?