Bernanke Provides Blueprint for Fed's Eventual Exit

Despite a Congressional hearing being canceled due to snow, Fed Chairman Ben Bernanke issued his prepared testimony on the Federal Reserve's exit strategy. Mr. Bernanke said while the economy continues to require the support of accommodative monetary policies, the Federal Reserve is confident that they have the right tools to reverse the currently very high degree of monetary stimulus.

Some of those tools include increasing the interest rates on bank reserves, reverse repos, term deposits and selling securities.

In the speech, Mr. Bernanke explained that the Fed's approach to the financial crisis can broadly be lumped into two parts - 1. Liquidity Programs, 2. Monetary Policy and Asset Purchases.

On the liquidity programs, Bernanke notes that the only facilities still in operation that offer credit to multiple institutions, other than the regular discount window, are the TAF and the TALF. These two facilities will also be phased out soon though he notes. The Fed is also is in the process of normalizing the terms of regular discount window loans, having reduced the maximum maturity of discount window loans to 28 days, from 90 days, and will consider whether further reductions in the maximum loan maturity are warranted. Total credit under all the programs has fallen sharply from a peak of $1-1/2 trillion around year-end 2008 to about $110 billion last week.

On the monetary policy and asset purchases, which included lowering the federal funds rate to 0 to 1/4 percent and purchasing Treasuries, MBS and agency debt, Bernanke notes as the economic expansion matures, the Fed will need to begin to tighten monetary conditions to prevent the development of inflationary pressure.

Of major focus is the $1.1 trillion in U.S. bank reserves with the Federal Reserve. Bernanke said one tool to lower bank reserves will be increasing the interest rate on reserves, which will 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.

Another tool to reduce reserves will be reverse repos. In a reverse repo, the Federal Reserve sells a security to a counterparty with an agreement to repurchase the security at some date in the future.

As a second means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers.

The Federal Reserve also has the option of redeeming or selling securities as a means of applying monetary restraint.

Bernanke doesn't expect that the Federal Reserve will sell any of its security holdings in the near term, however they 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.

On future sales of agency debt and MBS, the Federal Reserve said "any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions."

Bernanke expects that over the long run, the Federal Reserve balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities.

So this is a basic summary of Bernanke's plan to exit all the programs used to support the market. "Will the economy ever recover enough for them to be implemented?" or "Will they work?" are too big outstanding questions.