The Fed's Exit Plan

Today, Fed Chairman Ben Bernanke released the central bank’s exit strategy. His statement didn’t shed much light on the timing of the exit, but it provided some more specific details on policy tools. It is clear, though, that meaningful tightening won’t be happening anytime soon as the Fed Chairman explained the economy still needs “highly accommodative policy.”

The Fed will “before long” modestly increase the discount rate – the rate at which the Fed charges banks for emergency loans – but explained that this “should not be interpreted as signaling any change” in monetary policy. As expected, Bernanke also discussed paying a higher interest rate on excess bank reserves and reverse purchase agreements as the first tools for tightening credit.

The media seemed to emphasize the Fed’s plan to pay interest on excess reserves, which provides banks with some incentives to not lend all of their capital. In addition, if a bank can earn a reasonable return from the Fed, which poses no credit risk, other banks loans will be priced higher and credit will contract. Until reserve levels are much lower – and they are at unusually high levels – this tool along with targets for reserve quantities may play a bigger role in the Fed’s exit strategy than the fed funds rate.

Bernanke also explained that the Fed could sell securities to drain reserves from the banking system, but he did not anticipate doing so in the near term. The Fed is allowing agencies and MBS to run off and would sell them only if “the economy is clearly in a sustainable recovery;” however, the Fed is still rolling over Treasuries into new securities.

The obvious risk to the Fed’s exit plan is the error in execution. The amount of credit expansion that could be caused by the enormous stockpile of reserves at the Fed is largely unknown, as is the rate at which banks will be content keeping these reserves with the Fed. The timing of the exit is also a very delicate balance that we can’t expect will be perfect.

Any progress towards an exit, however, should be viewed as a positive at this juncture since the “emergency” rates in place are simply unnecessary.

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Peter J. Lazaroff, Investment Analyst