After spending years implementing extraordinary monetary policies, the Federal Reserve now has a formal exit strategy.
To normalize policy, the Fed will need to sell securities and increase its target for the federal funds rate, the interest rate at which banks lend to one another. The steps, first laid out in a July 2009 Wall Street Journal op-ed by Fed Chairman Ben Bernanke, were formalized during the June 21-22 Federal Open Market Committee meeting, according to meeting minutes released on Tuesday.
Once the Committee determines that normalizing policy will help to fulfill its dual mandates of curbing unemployment and inflation, the Fed will slowly stop reinvesting principal on the bonds it holds, kickstarting the process of drawing down its swollen balance sheet. It will also raise its target for the federal funds rate and, sometime after the first target increase, the Fed will start selling the securities it bought in order to boost the recovery with the aim of getting rid of them all within three to five years.
The Fed’s balance sheet more than tripled during the recession, from nearly $900 billion before the crisis to about $2.7 trillion in June, reflecting purchases made through emergency programs to keep the markets functioning. The balance sheet grew further as the Fed purchased securities in two rounds of quantitative easing.
All but one Fed official agreed to these key strategy elements, according to the FOMC minutes. Fed officials stressed that any discussions of an exit strategy were part of “prudent planning” and did not indicate that normalization would happen any time soon.
Fed officials were divided over what to do next. When the Fed’s most recent $600 billion bond-buying program, known as QE2, expired on June 30, it did not announce a third round of quantitative easing, but said that it would keep short-term interest rates low “for an extended period.” But the minutes from the June meeting revealed that some Fed officials are still open to the possibility of a QE3.
Some FOMC members said the Committee might have to provide more stimulus if conditions do not meaningfully reduce unemployment in the medium term, according to the minutes. Other Fed officials, however, thought the recent increase in inflation risks could change economic conditions and lead the Committee to begin normalizing policy sooner than anticipated.
Bernanke will testify before Congress on monetary policy and the economic outlook when he addresses the House Financial Services Committee on Wednesday. The Fed chair, who typically speaks cautiously to avoid roiling markets, is unlikely to mention the possibility of QE3.