Overview : U.S.

Federal Reserve’s Exit Measures

Fed Chairman Ben Bernanke has provided more clarity about the Fed's exit strategy from the current accommodative
policy stance. Following are the tools which FED is putting under consideration for its exit measures.

Normalize discount lending

Passively shrink MBS/GSE debt
Increase interest rate on reserves
Offer banks “CDs/Term Deposits”
Reverse repos
Outright asset sales
Fed Issues its own Bonds
Supplementary Finance Program

Source: Financial Times

In fact, Mr. Bernanke has outlined a possible sequence: 1) Test its tools for draining reserves, which include reverse
repos and term deposits…. 2) "Scale up" draining operations to drain more "significant volumes of reserves to
provide control over short-term interest rates." 3) Hike the interest paid on excess reserves rate. Bernanke said that if
the Fed deems it appropriate to exit more rapidly, it could choose to hike the [rate] at the same time it engages in
significant reserve draining.

Considering this stance by the central bank, it becomes very important to understand the possible development over
above mentioned exit measures in upcoming FED’s monetary policy meets.

Raising the Discount Rate: It could be seen as a technical correction back to a spread of 100 bps on the fed fund
target rate. Its impact over market has been little as markets are up with ample liquidity through other measures and
banks prefer less to avail the liquidity facility through discount window. Besides this, extended maturity of discount
window loans from overnight to 90 days has already been restored to overnight. Thus rise in discount rate is very
much on the cards of Federal Reserve and we expect the spread between discount rate and fed fund rate to widen
up to 100 bps before Federal Reserve begins its monetary policy tightening.
Interest rate on excess reserves: In October 2008 the Congress gave the Federal Reserve statutory authority to
pay interest on banks’ holdings of reserve balances. By increasing the interest rate on reserves, the Federal Reserve
will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term
funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal
Reserve Banks.

Bernanke provided clarity on this stating that “since it may be Mountain of Reserves on Fed’s Balance sheet
difficult to target the fed funds rate, given the conditions in
short-term money markets, the Fed may use the interest-paid-
on-excess-reserves rate in combination with targets for
reserve quantities as the guide. However, once reserves have
been sufficiently reduced, the Fed would return to targeting
the fed funds rate“. Fed would wait for the amount of
reserves kept at the Fed to reduce to that under normal
conditions. The reserves parked at the Fed are still very
high.

Draining of reserves Through Reverse Repos: Reverse repos

is one of the methods that the Federal Reserve has used
historically as a means of absorbing reserves from the
banking system.

Source: Bloomberg
In a reverse repo, the Federal Reserve sells a security to counterparty with an agreement to repurchase the security
at some date in the future. The counterparty’s payment to the Federal Reserve has the effect of draining an equal
quantity of reserves from the banking system. Recently, by developing the capacity to conduct such transactions in
the triparty repo market, the Federal Reserve has enhanced its ability to use reverse repos to absorb very large
quantities of reserves. The capability to carry out these transactions with primary dealers, using our holdings of
Treasury and agency debt securities, has already been tested and is currently available. To further increase its
capacity to drain reserves through reverse repos, the Federal Reserve is also in the process of expanding the set of
counterparties with which it can transact and developing the infrastructure necessary to use its MBS holdings as
collateral in these transactions. Fed has expanded the number of dealers so that when it does activate the
facility it can drain reserves at a brisk pace.

Term Deposits: the Federal Reserve is also

developing plans to offer to depository institutions
term deposits, which are roughly analogous to
certificates of deposit that the institutions offer to
their customers. The Federal Reserve would
likely auction large blocks of such deposits, thus
converting a portion of depository institutions’
reserve balances into deposits that could not be
used to meet their very short-term liquidity needs
and could not be counted as reserves.

It is expected that it will allow Federal Reserve to

drain hundreds of billions of dollars of reserves
from the banking system quite quickly. Chart
aside is indicating the Fed’s expectation of pulling
around $400Bn temporarily as savings with them.
Source: Federal Reserve of St. Louis
Supplementary Finance Program : It is a program essentially consists of Treasury bill issuance. The Treasury sells
bills to investors, and the cash paid to them effectively leaves the banking sector and is deposited in the Treasury’s
account at the Fed. That cash is held as a Fed liability – thereby offsetting the asset side of the Fed’s balance sheet,
and helping decrease reserves.
Markets were roiled in the aftermath of Lehman Brothers’ collapse and money market fund troubles. The Federal
Reserve was massively expanding its balance sheet to help restore liquidity to the system. Eventually the US
Treasury halted its Supplementary Finance Program (SFP), a scheme started in September 2008 to help finance
and manage the Fed’s balance sheet
Recently the provision for the SPF has been increased to $200 billion (approx no.) but has had no impact on the
markets. Further developments are awaited.

The above 3 measures are ways of draining cash from the economy but only for a temporary
period. The major two measures are “selling of assets” and “rising the target rate”, which
would permanently drain liquidity from the economy

Selling Of Assets: It is most likely to be prolonged over a number of years. Some Fed speakers have suggested
this to be 5 years. When they would start asset sales could be a highly debated point this FOMC though nothing
could be revealed in the statement and we would need to wait for the minutes to be released. Recent news reports
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have revealed that many Fed speakers are thinking of starting sales of assets as early as 3 quarter of this year. In
any event, officials anticipate that prepayments and redemptions would allow an estimated US$100-200 billion of
assets to runoff each year over the next few years.
Bernanke has said in his testimony that he does not expect to sell any of the Fed's security holdings until "after policy
tightening has gotten under way and the economy is clearly in a sustainable recovery." However, it will allow the MBS
[mortgage-backed securities] and agency debt to run off as they mature or are prepaid. It is less clear if the Fed will roll
over maturing Treasuries.

Increasing the Fed fund target rate – It should be the last measure fed will take and could be combined along with
sale of assets. Fed Chairman Mr. Bernanke has been very much rhetoric that implementation of exit measures
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doesn’t mean that FED is moving towards tightening of its monetary policy. In the FOMC meet on 28 April 2010, it
will be yet again crucial to see whether FED drops the “extended period” phrase or not. Market is expecting it to be
dropped which in turn suggesting for the FED to start raising Fed fund rate from somewhere around six months from
now i.e September/October.

Fed Issues its own Bonds: Another measure of draining liquidity could be by issuing its own bonds instead of
relying on Treasury-issued bills. The probability is very low for such a move and will be the first time in its history that
Fed has issued its own bonds. Even congress seems to be less keen for such a measure.