If we don’t execute an exit strategy carefully, we could be setting the fires for inflation down the road in the next year or two.

My own personal view is I think it's a little premature to be so confident that you want to pull all these things back right now because the economy still isn't growing very fast and we do have a very high unemployment rate.

From a technical point of view, I do not see a problem {with the Fed upholding its price stability mandate}– we do have the tools to contract our balance sheet and remove monetary stimulus when we need to do so, as Chairman Bernanke explained in detail in last month’s Monetary Policy Report to Congress. The harder problem is choosing when and how rapidly to remove stimulus as the recovery begins. I am certainly aware of the danger of aborting a weak, uneven recovery if we tighten too soon. But there can be a strong temptation to hesitate when emerging from a recession, awaiting conclusive signs of robust growth. Keeping inflation well-contained may require action before a vigorous recovery has had time to establish itself.

St. Louis Fed President James Bullard, speaking to reporters in Little Rock, Arkansas, said “it might not be necessary” {to purchase the full amount of MBS by year-end}.

…

While purchasing the full amount of $1.25 trillion in mortgage-backed securities may not be necessary, “even if we stop short, it would be close,” Bullard, 48, told reporters after a speech.

As reported by Bloomberg.

I think what we’re going to have to do is sell off the mortgage-backed securities portfolio as appropriate when the time comes. That would be a difficult decision to make. It would put upward pressure on interest rates. You wouldn’t want to do it too soon, but that’s what we’re going to have to do in order to work down this very large set of assets that we have on our balance sheet… At some point in the future we may have to start selling off as appropriate.

As reported by Bloomberg Audio.

[U]se of Fed liquidity facilities has declined sharply since the beginning of the year--a clear market signal that liquidity pressures are easing and market conditions are normalizing.

[P]ricing the facilities at a penalty rate has the added virtue of building an "exit strategy" into the structure of the programs. In pricing the PDCF, the Federal Reserve followed Bagehot's instruction by setting the interest rate on PDCF credit at the primary credit rate charged to depository institutions.
...
Actually, the pricing of a collateralized loan is multidimensional, and terms other than the interest rate are relevant. In particular, the terms on which collateral for a discount window loan is taken constitute an important additional dimension, and the haircut applied to the collateral is one of the most salient aspects. In establishing haircuts for the PDCF, the Federal Reserve sought to provide financing on terms that were less onerous than could be obtained in the markets during the crisis but also less attractive than those available in the markets in more routine circumstances. Thus, the haircuts set on the primary dealer facilities represented a generalization of the dictum to "lend at a high rate." This generalization has been applied to the Federal Reserve's other liquidity facilities as well. The fact that usage of the Federal Reserve's liquidity facilities has declined markedly--in several cases to zero--as market conditions have improved suggests that the Federal Reserve has been successful in pricing these programs at terms that represent penalties in more normal circumstances.

Although our ability to pay interest on excess reserves is sufficient to retain control of monetary policy, it is not bad policy to have both a “belt and suspenders” in place. As a result, we are working out ways to drain reserves to provide reassurance that we will not—under any circumstance—lose control of monetary policy.

Raising the rate of interest paid on reserve balances will give us substantial leverage over the federal funds rate and other short-term market interest rates...   The attractiveness to banks of leaving their excess reserve balances with the Federal Reserve can be further increased by offering banks a choice of maturities for their deposits.

Reverse repurchase agreements, which can be executed with primary dealers, government-sponsored enterprises, and a range of other counterparties, are a traditional and well-understood method of managing the level of bank reserves. If necessary, another means of tightening policy is outright sales of our holdings of longer-term securities. Not only would such sales drain reserves and raise short-term interest rates, but they also could put upward pressure on longer-term interest rates by expanding the supply of longer-term assets...

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit My colleagues and I believe that accommodative policies will likely be warranted for an extended period.  At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.  The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

We know we cannot have this highly accommodative policy without risking some pretty difficult inflationary consequences. So let's deal with that.

Once we get the policy rate in a range ... around neutral -- I cannot identify what neutral is, but I know that it is not a quarter of a percentage point over a long period of time -- you stay within that range.

What we need to do is get to some level of policy that is more constrained, around a neutral level, and then let the economy work its way through.

As reported by Reuters.

When it’s necessary to withdraw the extraordinary stimulus we have put in place, we won’t hesitate. The Fed was created as a politically independent central bank, and that tradition is deeply embedded in our culture and practice.

Personally, the idea of our tightening from where we are, I don't see it in the immediate future.

[A] significant portion of our balance sheet may not shrink on its own or at the appropriate rate. We need tools to reduce it actively so that monetary policy can be easily recalibrated. In this respect, we can be as creative on the way out as we were on the way in; or, put another way, we can be creative with our liabilities the way we have been creative with our assets.