High anxiety over the Fed’s exit

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The Federal Reserve (the Fed) has promised to continue its expansionary efforts of pumping more money into the economy well into 2015.

The Fed has vowed to continue buying mortgage-backed bonds (MBBs) to the tune of $40 billion a month. At this rate, their balance sheet will tip the scales at $4 trillion by the end of 2013.

Many are expressing their anxieties over the Fed’s exit strategy (let alone their asset inflation misconceptions). They argue that the Fed’s balance sheet of bond acquisitions has become unwieldy.

In an effort at transparency, the Fed made their original exit plan clear in mid-2011. Under the current plan, the Fed will unwind their balance sheet with repurchase agreements and by offering term deposits. Both are strategies to allow their assets back into the market while at the same time placing a limit on their velocity.

In other words, the Fed will sell back the bonds to withdraw money from circulation, but only under the condition that purchasers hold them for some time.

Regardless of the strategies used to “normalize” the markets, everyone seems to agree that in order to do so successfully, it will be a long, slow process.

Fears are running high. Perhaps we can explain exactly what the fears are over, and then try to dispel them.

If the Fed sells all of the bonds it holds too quickly, thus withdrawing billions of dollars from the market at once, bond prices will plummet and bond yields will go up. Prices will plummet due to a glut in the supply and bond yields will skyrocket since bond prices and yields work inversely.

Thus, as interest rates rise demand is dampened, and disinflation or even deflationwould occur. That would send investors into cash, derailing the recovery.

If the Fed does not withdraw quickly enough, the huge amounts of cash they have injected into the system could take off running, resulting in hyperinflation.

However, neither scenario will occur and the reasons for this are varied and many.

The Fed has more than one option to wind down their balance sheets. The most conservative option would be to hold their newly purchased assets to maturity. In which case, the risk of either inflation or deflation would be nil.

On the other hand, the Fed also has control of interest paid on lender reserves (IOR). Ifinflation begins to rise, the Fed can increase the rate they pay on reserves, which will recapture lender dollars and keep them from flooding the money supply.

However, the more imminent danger in this scenario is deflation, since we are already at the zero lower bound interest rate. Should the inflation rate begin to fall, the only option would be for the Fed to go negative. Thus, they would charge lenders for holding excess reserves.

The less exciting reality that we face for the moment is likely more of the same: an extended period of low rates, coupled with low prices and low demand through 2014. This will continue to be the norm even as the Fed slowly puts an end to their bond buying and raises interest rates.

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