Commentary: A Clearer Picture Emerges on US Monetary Policy

The Federal Reserve System made news yesterday with two announcements. The system will more aggressively expand its balance sheet in the coming months, purchasing an additional 45 billion in US Treasury securities on top of the 40 billion in monthly MBS purchases announced in September.  The Fed has also announced specific thresholds for when it might stop easing-- until unemployment is below 6.5 percent and/or inflation is above 2.5 percent.  From this news, a clearer picture has emerged as to outlook for US monetary policy.  First, the System's balance sheet will almost certainly reach 4 trillion dollars.  This confirms the expectations of many analysts, and will mean that the unwinding of the Fed's balance sheet will take even longer than originally expected.  Secondly, on Wednesday Bernanke tacitly acknowledged during his post meeting press conference the fact that rate increases won't be possible until the Fed sells enough securities to soak up the mass of excess banking reserves.

" It is worth noting that the goals of the FOMC’s asset purchases and of its federal funds rate guidance are somewhat different. The goal of the asset purchase program is to increase the near-term momentum of the economy by fostering more accommodative financial conditions, while the purpose of the rate guidance is to provide information about the future circumstances under which the Committee would contemplate reducing accommodation. I would emphasize that a decision by the Committee to end asset purchases, whenever that point is reached, would not be a turn to tighter policy. While in that circumstance the Committee would no longer be increasing policy accommodation, its policy stance would remain highly supportive of growth. Only at some later point would the Committee begin actually removing accommodation through rate increases. Moreover, as I have discussed today, the decisions to modify the asset purchase program and to undertake rate increases are tied to different criteria."

Bernanke cannot directly state that the Fed could not raise the Federal Funds Rate today, for fear of undermining the central bank's credibility.  However, we are beginning to see the contours of what the exit strategy will look like.  The Fed will cease asset purchases, the Fed will maintain its zero interest rate policy for a time, the Fed will slowly sell securities to soak up the mass of excess reserves, and finally, the Fed will undertake rate increases.  This process will take at least five years.  In short, along the roadmap to monetary tightening, one can see many of the signposts recently pointed out by your humble analyst.