How will the Fed withdraw all that liquidity?
It seems like a long time off, but the Fed is going to eventually have to withdraw all of the excess liquidity it has created when the economy recovers. However, doing so will prove tricky. First, we have debt deflationary situation in the United States which could lead to a serious double-dip if a restrictive monetary policy is applied too early. Moreover, the Federal Reserve has added a considerable amount of non-Treasury assets to its balance sheet. Selling these assets on or even returning to their rightful owners those assets used as collateral for loans from the Fed will be a mean feat. This is one reason that many are pointing to inflation as a worry already.
In that vein, David Greenlaw at Morgan Stanley had a few good comments today about a timetable for withdrawing the excess liquidity.
Three phases of an exit strategy. In our view, there are three phases of an exit strategy: passive, active and rate hikes. Some of the special liquidity facilities that were introduced by the Fed in response to the credit turmoil will wind down of their own accord – indeed, several of the largest programs are already showing such a pattern. This is what we refer to as a ‘passive’ exit. Other programs, such as the Treasury, agency and MBS open market purchases, will require a more active approach. While we view outright sales as unlikely due to potential significant market disruption and political constraints tied to recognizing loses, there are several other tools that might be employed (such as reverse RPs, expanded SFP bill issuance, reserve requirement changes, etc.). The Fed can and should provide specifics on its approach to the ‘active’ portion of the exit strategy in the not-too-distant future, in our view. Also, the Fed will likely need to adopt tools that will allow it to push the Fed Funds rate higher prior to complete exit from QE. As we learned in late 2008, the interest on reserves program does not necessarily put a hard floor under the federal funds rate. Although the Fed believes – and we concur – that this was partly related to unusual pressures on bank balance sheets, the Fed’s credibility could receive a boost if it took steps aimed at avoiding a repeat of this problem. This might be done, for example, via an expansion of the interest on reserves program to non-bank institutions or by prohibiting some entities from participating in the federal funds market.
While the FOMC could conceivable include a reference to the exit strategy in the official statement, it might be best to deal with any substantive communication on this front at Bernanke’s upcoming Monetary Policy Report to Congress, scheduled for July 21.
Given the difficulty that both qualitative easing and debt deflation present to the Fed in withdrawing liquidity, Greenlaw is correct that we would all be well served if the Fed telegraphed its intentions. Recent gyrations in the Treasury market demonstrate that many participants expect future inflation to rise considerably from present levels. The Fed’s mapping out a path to policy normalization would be a bolster to Treasuries, and consequently to mortgage holders and corporate bonds as well.