The Federal Reserve Still Doesn’t Have A Roadmap For Its Exit Strategy!

CNBC.com – 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. 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.

Comment

CNBC’s Steve Liesman is a Federal Reserve mouth-piece much like The Wall Street Journal’s Jon Hilsenrath.

In the story and video above Steve talks about the Federal Reserve’s “exit strategy” and “sequencing.” Exit strategy is the phrase the Federal Reserve uses for both raising rates and reducing the size of the balance sheet. Sequencing refers to the order in which the different facets of the exit strategy occurs.

The Federal Reserve’s sequencing has four parts:

Changing the Language – This refers to the Federal Reserve dropping the phrase “extended period” from the FOMC statement. In Bernanke’s press conference last week, he suggested that “extended period” refers to a period of a few meetings, so dropping it means the next step of the exit strategy will occur a few meetings later. This will be the first thing the Federal Reserve will do when the exit strategy starts.

Reinvestment Policy – This refers to the Federal Reserve ending its policy of reinvesting mortgage coupons. This could be a source of some confusion. Recall that before QE2 began in November, the Federal Reserve started a reinvestment policy in early August 2010. QE2 had a goal of increasing assets on the Federal Reserve’s balance sheet by $600 billion by June 30, 2011. QE2 will end automatically unless it is renewed by the FOMC. The reinvestment of MBS proceeds, on the other hand, goes until the Federal Reserve votes to end it. Bernanke said he expects reinvestment to continue after June 30. Some are referring to this as QE2.5. According to Bernanke, ending this reinvestment policy would be the second step in the exit strategy, which presumably would happen a few meeting after the language is changed (extended period is dropped).

The first two steps of the sequencing are not controversial. The next two steps, according to Liesman, were the subject of “intense” and “more robust” debates at last week’s FOMC meeting than Chairman Bernanke suggested at his press conference.

Interest Rates – This refers to hiking interest on reserves in the hope that other short-term rates would follow. However, as we noted last month in Why The Federal Reserve May Have A Hard Time Raising Rates and Is Interest On Reserves A Meaningful Tool?, the new FDIC fee imposed on repo transactions would make it difficult for the interest on reserves to affect market rates. Liesman said as much in the video above. See the two charts below.
Asset sales – This refers to not only selling the massive hoard of securities, but also using new tools like reverse repos and term deposits. We have long suggested these new tools will have very limited success, if any at all.

Why Should We Care?

Our interpretation of these internal debates is that the Federal Reserve is worried interest on reserves will not be an effective tool in raising market interest rates. As we noted last month, this tool was ineffective in creating a floor on the funds rate in 2008. Additionally, the FDIC fee must be worrying Federal Reserve officials. In order for interest on reserves to be effective, the Federal Reserve might have to hike a lot (say 75 basis points) to get a small hike in market rates (say 25 basis points). Such an over-sized hike carries the risk of being misinterpreted as a panicked move by the FOMC.

Because of this, some in the FOMC seem to be arguing that assets should be sold before rates are raised. This is a sequence that we have long favored. Unfortunately, reducing the balance sheet to a more normal level will likely require a prolonged period of asset sales (which is why we did not favor QE2). If inflation expectations reach unacceptable levels, the market will not have this kind of patience. This could force the FOMC’s hand to raise interest on reserves by a large margin, bringing with it the same problems mentioned above.

We believe the Federal Reserve knows all this, which is why they had “intense” debates about the exit strategy last week. They understand that unacceptably high levels of inflation expectations are not good and could lead to a lot of market misunderstandings and volatility. The bottom line is they are still not sure how or what sequence they should use because they are not sure what will happen when the exit strategy begins. They are guessing, like the rest of us.