• Given the current environment, the Fed will closely watch credit growth, as well as inflation and the output gap
  • The Fed’s new policy tools and the subdued economic environment will allow it to lower the possibility of high inflation resulting from unchecked credit growth
  • The biggest challenge for the Fed in implementing its exit strategy is managing the huge amount of excess reserves and mortgage-backed securities

Introduction

During the most recent financial crisis, the Federal Reserve (Fed) increased money supply significantly to provide liquidity in the economy and to avoid a meltdown in markets such as Mortgage Backed Securities (MBS). As opposed to the usual Open Market Operations, during the crisis the Fed bought $1tr worth of MBS, aside from other liquidity programs. Although the Fed managed to solve the liquidity problem in the market, the excessive increase in money supply between 2008 and mid-2009 will limit the U.S. economy’s ability to absorb some portion of the excess reserve and the Fed’s ability to maneuver if banks start to use these reserves. A big decrease in excess reserves has increased the probability of high inflation rates.

As Milton Friedman noted, in the long run, “inflation is always and everywhere a monetary phenomenon.” Currently the U.S. money supply is at a historical high, but the U.S. has not yet experienced inflationary pressures because depository institutions are holding the huge amount of excess reserves at the Fed. Although depository institutions receive a zero interest rate on such funds, these organizations prefer to stay liquid. This implies that banks do not want to assume more risk by increasing lending. However, some economists argue that if banks start to lend their excess reserves, the economy will begin to struggle with inflationary pressures.

This paper will explore these issues and provide an analysis for the Fed’s exit strategy from the extraordinary loose monetary policy. The Fed faces an unprecedented scenario unlike any in its long history. As such, in the following sections we provide a number of different angles on the Fed’s strategy-making process. We start with a review of Fed Chairman Ben Bernanke’s writings and speeches on the conduct of monetary policy at very low short-term interest rates. Next, we describe the current state of knowledge about monetary policy operations at central banks.

With an understanding of Bernanke’s views and the role of monetary policy in the economy, we then turn to three areas that determine the Fed’s exit strategy: the sustainability of economic recovery, the determinants of monetary policy, and the role of credit growth in the Taylor rule. We conclude with a quantitative analysis of these influences on the exit strategy.