Quantitative easing - What do we know about the Fed's exit strategy?

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For much of this year there has been speculation about when the US Federal Reserve (the Fed) will begin tapering quantitative easing (QE) as a first step to normalising monetary policy. This would be a welcome development for Australia because the Australian dollar, which remains at uncomfortably high levels, would likely depreciate. This note provides a quick summary of what the Fed has said about its exit strategy. It follows on from an earlier flagpost Exiting quantitative easing – the need for a deft touch and some luck.





The Fed has clearly done a lot of work to prepare for exiting QE and restoring its balance sheet to a more normal configuration in the longer term. An important first step was ensuring it had the necessary tools to begin to tighten monetary policy when economic and financial conditions justify such a move.

The Fed Chairman, Ben Bernanke, outlined how the Fed had augmented its toolkit in a statement in 2010. This included Congress giving the Fed statutory authority to pay interest on balances that banks hold at the Federal Reserve Banks. This should provide a floor for short-term market interest rates. By changing this interest rate the Fed can adjust the incentives for banks to hold reserves to a level appropriate for monetary policy. In the context of exiting QE, it gives the Fed better control of the level of excess reserves flowing into the financial system. As the US economy strengthens the Fed will be keen to avoid bank lending reaching levels that lead markets to expect higher inflation.

The June 2011 minutes of the Federal Open Market Committee (FOMC) included a set of principles to guide the normalisation of monetary policy. These principles suggest a multi-step process involving:

• The FOMC will likely first ease reinvesting some or all of the proceeds from maturing securities it holds on its balance sheet.
• The FOMC will at the same time or at some point further down the track signal a change in the likely path of the federal funds target rate. By doing this the markets would be put on notice that the federal funds rate is expected to rise to effect a further tightening of monetary policy in response to improving economic and financial conditions.
• When economic conditions warrant the FOMC will begin to raise the target for the federal funds rate. From this point, changing the level or range of the federal funds rate target will be the primary means of adjusting monetary policy. During the normalisation process, the FOMC will adjust the interest rate it pays on excess reserves to bring the federal funds rate toward its target.
• Sometime after the first increase in the federal funds rate the FOMC will likely commence selling assets. The pace of sales will be calibrated to reflect changes in the economic outlook or financial conditions.
• The process of returning to a normalised balance sheet, involving the sale of housing related securities, will occur over a two to three year period.

Following the June 2013 FOMC meeting the Fed Chairman indicated that as part of prudent planning the committee had been reviewing the above principles in recent meetings. While the FOMC continues to consider these broad principles remain applicable, the Chairman did identify one notable change. As first articulated the principles envisaged the FED would offload mortgage‑backed securities as part of normalising its balance sheet. This reflects a view the Fed’s portfolio should consist mostly of Treasury securities. However, it now appears the FOMC does not envisage the sale of mortgage-backed securities during the process of normalising monetary policy. However it remains possible that in the longer-term the Fed might use limited sales to reduce or eliminate its residual holdings of these securities.

The first step to normalising monetary policy will be the Fed beginning to slow the pace of its asset purchase program. The Fed is currently purchasing US$40 billion of mortgage‑backed securities and US$45 billion of longer-term Treasury securities each month. The Fed will be hoping to achieve a smooth and gradual phase out of asset purchases over a number of months that does not trigger excessive market volatility. It is likely to be a case of ‘learning by doing’ as the Fed tries to gauge how the US economy and financial markets are responding to the tapering of asset purchases. A lot is riding on the Fed getting the pace of tapering right. If the Fed tapers too quickly the US economy could slow down.

It is likely that tapering the asset purchase program will spark speculation about when the Fed will start raising the federal funds rate back to more normal levels. Following the October 2013 meeting the FOMC reaffirmed its view that the federal funds rate will remain at exceptionally low levels as long as the unemployment rate remains above 6.5 per cent, inflation is forecast to be no more than half a percentage point above the Committee's 2 per cent longer-term target, and inflationary expectations remain well anchored.

By articulating a set of principles and providing forward guidance about the likely path of the federal funds rate the Fed has reduced some of the uncertainty for markets about how the process of exiting QE and normalising monetary policy is likely to unfold. However, the Fed has always indicated this is not set in stone but will depend critically on economic and financial conditions. As the Fed’s thinking continues to evolve and adjust to changing circumstances it will be important this is clearly communicated to the markets if excessive volatility and unintended consequences are to be avoided.