Overview: Federal Open Market Committee’s 2011 exit principles

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Kansas City Fed President on economic and monetary policy outlook (Part 3 of 5)

(Continued from Part 2)

June, 2011, exit principles

As the economy improves, the Fed will have to start neutralizing the balance sheet. While the Fed has curtailed its asset purchase program to $45 billion ($25 billion in Treasuries (TLT) and $20 billion in mortgage-backed-securities (MBB)) a month from the original $85 billion a month, the balance sheet will continue to expand, although at lower rate, until the end of the asset purchase program.

Once the asset purchase program ends, the Fed will have to start “normalizing” its balance sheet. The Fed will also have to start increasing the currently unusually low Fed funds rate. Ms. George mentioned that “The timing and pace will have a significant influence on whether the economy experiences a hard or soft landing.” In other words, if the market reaction to a rate hike is subdued, the magnitude and the pace of the rate hike might be high. If the market reacts strongly to even a small rate hike, the process of increasing the Fed funds rate to normal levels might be gradual.

In the exit strategy (the strategy to normalize the Fed’s monetary policy) released in June, 2011, the Federal Open Market Committee (or FOMC) planned to stop reinvesting the maturing principal on the Treasury securities (IEF) that the Fed holds. As a result, the Fed’s balance sheet will start normalizing when securities mature.

Also, the exit principles in June, 2011, suggested that the FOMC should modify its forward guidance on the path of the Fed funds rate. The principles also suggested taking necessary steps to reduce the unusually high amount of reserves held in the banking system (currently $2.7 trillion against $10 billion prior to 2007).

The final aspect of the 2011 exit principles, as Ms. George noted, “was to return the (Fed’s) balance sheet to a more-normal size and composition.” While the balance sheet has increased since then, Ms. George said that the exit principles still apply. The Fed’s balance sheet size stands at $4.5 trillion compared to $2.5 trillion in 2011 and $870 billion in August, 2007.

What will the FOMC do with its balance sheet after the bond-buying program ends?

Ms. George thinks that allowing the balance sheet to shrink due to “passive runoff” before the first rate hike is an appropriate way to normalize the size of balance sheet. Passive runoff is slowly scaling down the Fed’s balance sheet size by discontinuing the reinvestment of principal of maturing securities.

The subsequent rate hike would be negative for most fixed income securities (BND), especially the Treasuries (IEF). As the interest rates go up, prices of fixed income securities (AGG) go down. Interest rates and prices of most fixed income securities share a negative relationship.

To learn more about Ms. George’s outlook on the economy and monetary policy over the short-to-medium term, continue reading the next section of this series.

Continue to Part 4

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