Fed Chair Bernanke on Federal Reserve’s Exit Strategy

Fed Chief Bernanke outlines in his written testimony –which was postponed because of a major snowstorm in Washington, but the Fed released Bernanke’s testimony anyway — the Federal Reserve’s exit strategy and the steps that must be taken to unwind monetary stimulus and the agency’s, currently, very accommodative policy stance.

From Fed: “I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery”, Bernanke said. “However” he continued, “to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid. The Federal Reserve is currently rolling over all maturing Treasury securities, but in the future it may choose not to do so in all cases. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities. Although passively redeeming agency debt and MBS as they mature or are prepaid will move us in that direction, the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted. Any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions.”

In the following paragraph Bernanke talks about a possible, temporary change in the Fed’s operating target — if the IOER, that is, keeps failing in terms of setting a floor under the funds rate.

“As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that 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 an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.”

Bernanke reiterated during his testimony the fact that the central bank was likely to keep the interest rate historically low for “an extended period”. He also pointed out that the expanded Fed programs, including large-scale purchases of MBSs from Fannie and Freddie, “are likely to generate significant positive returns for taxpayers.”

In the long run, Bernanke anticipated that as the Fed balance sheet shrinks back to more normal levels, “most or all of its security holdings will be Treasury securities.”