Thoughts on the Federal Reserve System's Exit Strategy
Federal Reserve Bank of Minneapolis Economic Policy Paper 10-1
Posted: 13 Apr 2010
Date Written: March 1, 2010
Abstract
Now that global financial markets are beginning to stabilize, the Federal Reserve is considering how best to reabsorb liquidity so as not to create inflation as the economy revives. Three broad strategies for managing monetary reserves in the United States include: (1) paying interest on excess reserves, (2) managing interest rates on short-term deposits, and (3) selling back financial assets such as mortgage-backed securities. From a theoretical standpoint, these strategies are identical; which approach is employed is not of fundamental macroeconomic importance. Nevertheless, this note argues that several potentially large dangers associated with the first two strategies have been overlooked, whereas a frequently cited weakness of asset sales has been exaggerated. The best course is a careful blend of all three approaches, with strong emphasis on a preannounced program of gradual sales of financial assets. Such a joint strategy is likely to have the highest probability of success in draining reserves, with minimal risk.
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