Wednesday, July 7, 2010

The Multiple Faces of the "Exit Strategy"

The term "exit strategy" has become one of the most popular in the financial lexicon over the last year or so, following the unprecedented amount of liquidity injected into the system by the Fed in the midst of the financial crisis in 2008-09. It has widely come to be viewed as referring to the process that the Fed will need to engage in at some point to start normalizing financial market conditions. In one of its most linear interpretations, the term is considered as synonymous to the beginning of the Fed's raising short-term rates. Underlying such an interpretation is the frequent misconception that the absorption of excessive liquidity is tantamount to tightening policy.

In reality though, "exit strategy" is a significantly more multi-layered enterprise than that.

The process of starting to normalize liquidity levels in the financial system is not necessarily linked to a higher federal funds rate and, in fact, the timing of the former is not likely to coincide with that of the latter, but it will most probably precede it.

In the last few months, a number of Fed officials have, in nearly explicit terms, drawn the distinction between the project of asset sales from the Fed's bloated $2.3 trillion portfolio and the prospect of rate hikes. In the most recent FOMC minutes available (April 27-28 meeting) there was a fairly extensive discussion, including a number of specific steps to be considered, regarding the gradual winding down of the Fed's portfolio in the future, while there was unwavering commitment to the "extensive period" language concerning the near-zero fed funds rate

Moreover, several FOMC members have been on record in recent weeks (including richmond Fed President Lacker, St. Louis Fed President Bullard, and others) offering their own take, and -in some cases- specific ideas, on the future of the Fed's asset sales, while, with the well-publicized exception of Kansas City Fed President Hoenig, there is essentially no questioning of the premise that the fed funds rate will remain near zero beyond the end of the year.

The reason for the dichotomy in terms of how these two tracks are treated by the Fed is that any gradual lightening up of the Fed's portfolio is highly unlikely to have any impact on the fed funds rate, the latter legitimately considered as the true barometer of the degree of tightness of monetary policy. Such transactions would mostly take the form of a steady, modest stream of outright sales out of the nearly $1.2 trillion MBS portion of the Fed's portfolio, or, (to a lesser degree over the next year or so, given the long maturities involved) simply allowing for some of those holdings to run-off slowly. In any event, such a process will not affect the fed funds rate, as the latter will require a very different, direct, set of actions by the Fed (namely, raising the interest rate paid on bank reserves from its current 0.25%, as well as an aggressive program of reverse RPs).

For simple operational as well as tactical reasons, the Fed will almost certainly activate the process of a carefully controlled downshifting of the size of its portfolio ahead of any short-term rate hikes. A slow reduction in its portfolio over a number of months will achieve the dual objective of 1) leaving a lesser, more manageable, amount of liquidity to be mopped up later by reverse RPs and higher rates offered on bank reserves when the time for "real tightening" comes, and 2) avoiding to unsettle financial markets prematurely by moving ahead with a highly emotional overt rate hike, as the winding down of its portfolio is a far more discrete- almost, behind-the-scenes process.

The various modalities that the implementation of the "exit strategy" ahead can take were highlighted in some interesting comments that Richmond Fed President Lacker made earlier this week (, where he argued that the Fed should sell MBS out of its current portfolio and buy Treasuries. Such an operation would leave the total amount of liquidity in the system intact but would start restoring the Fed's portfolio to its more traditional, pre-crisis, composition of holding mostly Treasury securities. In a way, this would be a useful preliminary move toward an eventual normalization of financial market conditions over the next couple of years.

The minutes of the June 22-23 FOMC meeting that will be released next week (July 14) may offer more of an insight into the discussion among policymakers about the issue of the Fed's portfolio ahead. Although the activation of a mechanism to alter the configuration and size of that portfolio is still some months ahead, it is important to recognize that it will likely precede- quite possibly by an appreciable margin- the timing of any actual rate hike. In other words, the "exit strategy" is not a monolithic project but more like a multi-faceted affair, not all of which need to have an overt effect on rates.

Anthony Karydakis