Wednesday, May 25, 2011

FOMC continues “exit strategy” musings

The most interesting aspect of the recently released minutes of the April 26/27 meeting of the Federal Open Market Committee (FOMC) was their continued musing on the appropriate way to tighten monetary conditions.

In terms of timing, the majority of the committee does not see a tightening this year with some (but not all) participants concerned that “an early exit could unnecessarily damp the ongoing economic recovery.” We concur. We don’t see a tightening in conditions until 2012.

The committee recognises the ongoing weak nature of the recovery but has also ruled that out as a sufficient reason for any further loosening in conditions. Some members made the point that “there would need to be a significant change in the economic outlook…before another program of asset purchases would be warranted”.

The discussion about how to go about the tightening, in particular the phasing of the different aspects, is fascinating and appears to remain unresolved at this point. That’s not necessarily a bad thing. There is still a bit of time on the committee’s side and the transparent nature of the discussion is conditioning the market to the full range of possibilities.

There is a growing consensus around the first step at least. This will most likely be ceasing to reinvest principal repayments on the Fed’s MBS holdings. This would most likely happen around the time the Fed drops its commitment to leave the fed funds rate on hold “for an extended period”.

The next step would be to start draining reserves using the term deposit and reverse repo facilities. The Fed have been flagging these as “exit tools” since we first started talking about exit strategies (prematurely) in 2009. When that starts to happen, especially with regard to when to raise interest rates, and then whether the emphasis on tightening should be on asset sales or interest rate increases, is a still evolving story.

The committee seems to be in favour, at least at this point, in leaving asset sales until after short-term interest rates are rising. This is not what I had been thinking. My assumption has been the Fed would want to be a good way through its balance sheet normalisation process before raising rates. However, the argument that in raising rates first then allows the committee to use interest rates as their primary policy tool should an easing become warranted is compelling. It also means the committee can undertake its asset sales on a “largely predetermined and preannounced” path. Hmmmmm. Looks like I’ve got more musing to do too.