Just as there is slack, there is also an enormous amount of stimulus in the economy and coming into the economy...Being too slow to remove our expansionary actions would very likely be inflationary.

If we’re going to go the supplemental financing programme route, we need SFPs to be exempt from the debt ceiling. The other approach is the Fed bill approach. It’s not subject to the debt limit. [Fed bills] can be sold broadly in the market, for example to money-market mutual funds. The problem is then there are two issuers of US government obligations. You don’t want both a three-month Fed bill and a three-month T-bill. It creates confusion. I don’t think it’s a big problem; lots of central banks have authority to issue central bank bills. We don’t want to be in the Treasury’s way so we’d probably restrict maturity to less than 30 days so they have 30 days and up.

I think Treasury is quite sympathetic to letting us do one or the other. We’d like Congress to consider it. It’s nice to have—as opposed to critical. That said, if I could get a belt and suspenders, I’ll take belt and suspenders. As long as people are worried about whether we have adequate tools, it makes sense for us to get more tools even if we don’t think we need them.

First of all, on the technical aspects of unwinding, we are confident that we can unwind this process...

As conditions return to normal we can simply shut down those short-term programs. That's step number one.

Step number two and very important is the interest on Reserve's authority that the Congress gave us last year by setting an interest rate on reserves close to our target for the short-term interest rate, we make it very unlikely that banks would want to lend out in the overnight federal funds market at a rate below that interest rate. That's a very important tool and many central banks around the world effectively use that tool. We have additional ones though including reverse repurchase agreements and, if necessary, sales. But there are a number of ways that we can address this problem.

So I think from a technical point of view, I think we are able to address the current level of our balance sheets.

In response to a question about the Fed's exit strategy

The markets won’t be fooled by artificially low rates for long.  Market participants realize that a period of high deficits and accommodative monetary policy are an invitation to increased inflationary pressure.  I suspect we are experiencing the first signs of the markets’ concerns in the rising rates and increased volatility in longer-term Treasury markets.

[S]ome of the Treasury and GSE debt that we are acquiring will run off over the next few years without any need for outright sales, as will some of the MBS as individuals sell or refinance their homes.

Looking ahead, prognosticators this year have divided into several different camps. Some believe that high unemployment necessarily will lead to continually falling inflation for several years, and they are concerned about the risk of outright deflation. I personally have thought the risk of deflation was overstated, and for the first three months of this year, inflation has averaged 2 ¼ percent – both core prices and overall prices. Another camp places significant weight on the public’s expectations, and as near as we can figure, those are fairly well anchored around 2 percent. And finally, a third camp sees the rapid growth in our balance sheet, notes the historical association between rapid money growth and subsequent inflation, and wonders whether inflation will accelerate when the economy begins to recover.

Where do I stand? While I gravitate to the second camp – the one that views stable expectations as likely to anchor inflation in the near term – members of the third camp have identified inflation risks that are quite legitimate. The challenge for us on the Federal Open Market Committee will be to shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation. The danger is that we will not shrink our balance sheet and tighten policy soon enough when the recovery emerges to prevent rising inflation. Choosing the right time to withdraw that stimulus will be a challenge, and I believe it will be very important to avoid the risks of waiting too long or moving too slowly.

[I]f economic growth resumes in the United States as I expect, the threat of deflation should diminish commensurately... As for liquidity provision and inflation, it is important to emphasize that the relation between growth in the money supply and the path of prices holds in the long run, over periods of at least five and more likely 10 years. Thus, there is ample time for the Federal Reserve to withdraw excess liquidity as appropriate.

We have a plan in place. We are trying to strengthen and improve it. Some of the components are, first, that many of the short-term programs will either wind down naturally or can be wound down. That's about up to $1 trillion of balance sheet that can be wound down through that process.

Secondly, very importantly, Congress gave us last year the ability to pay interest on reserves. By paying interest on excess reserves, banks will hold their reserves with the Fed. That will allow us to -- to raise interest rates even if excess reserves remain very substantial in the system. So that tool itself will be a very powerful tool. 

Third, we're looking at what's called reverse repurchase agreements, which essentially would allow us to finance on a short- term basis some of our asset holdings with non-bank investors, such as securities dealers or others. That would drain excess reserves from the system and also have the same effect.

Fourth, Treasury deposits at the Fed drain reserves from the excess -- excess reserves from the system, as they have done last year, for example.  And finally, if necessary, we can always sell some of our assets into the market.

So we have a number of options. The exact timing and sequencing remains to be seen. We're looking at that. We hope to release more information about that. But we -- we do believe that we have all the tools that we need to -- to exit, to help this economy get back to a -- a sustainable growth path, but also to ensure that we come out of this with price stability.

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In response to two questions about the Fed's exit strategy

However, our newly purchased Treasury securities and MBS will not mature or be repaid for many years; the loans we are making to back the securitization market are for three years, and their nonrecourse feature could leave us with assets thereafter. But we have a number of tools we can use to absorb the resulting reserves and raise interest rates when the time comes. We can sell the Treasury and agency debt either on an outright basis or temporarily through reverse repurchase agreements, and we are developing the capability to do the same with MBS.

We have a number of tools we can use to reduce bank reserves or increase short-term interest rates when that becomes necessary. First, many of our lending programs extend credit primarily on a short-term basis and thus could be wound down relatively quickly. In addition, since the lending rates in these programs are typically set above the rates that prevail in normal market conditions, borrower demand for these facilities should wane as conditions improve. Second, the Federal Reserve can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities. Of course, for any given level of the federal funds rate, an unwinding of lending facilities or a sale of securities would constitute a de facto tightening of policy, and so would have to be carefully considered in that light by the FOMC. Third, some reserves can be soaked up by the Treasury's Supplementary Financing Program. Fourth, in October of last year, the Federal Reserve received long-sought authority to pay interest on the reserve balances of depository institutions. Raising the interest rate paid on reserves will encourage depository institutions to hold reserves with the Fed, rather than lending them into the federal funds market at a rate below the rate paid on reserves.⁵ Thus, the interest rate paid on reserves will tend to set a floor on the federal funds rate.

(Note:  emphasis added)

The steps we have taken need to be seen as part of an effort by the government to smooth the transition of our financial sector and economy to a more sustainable situation. Both markets and regulators are going to press financial firms to employ less leverage. Similarly, households will need to save more of their income over time, and in that process domestic spending will be brought more into line with our nation's potential to produce, thus reducing our dependence on foreign savings. However, the speed and force of the private-sector adjustments risk overshooting...

However, while near-term stability seems to require slowing these adjustment processes, we must put in place frameworks for exiting these programs if we are to end up with a market-based economy that is more balanced and more resilient. Over time, the Federal Reserve must reduce its lending; the government must put its deficits on a distinct downward track; financial institutions must retire government assistance and operate on their own.    

[M]oney market funds have reduced their reliance on the Fed liquidity facility that was designed to help them – the asset-backed commercial paper money-market mutual fund liquidity facility, or AMLF. This experience provides a clear example of how improved market conditions provide incentives for financial firms to reduce reliance on our facilities. We expect this to be the case for many of our facilities as the economy and financial markets gradually improve.

The art of this is to set the terms at a level that when conditions normalize, people won’t want to come get this financing from the government because it won’t be economic to do it. So the art in this is to set the price for the financing at a level that is very conservative in normal times but still economic in times of crisis, and that’s the way this works. That’s the basic [unintelligible] that’s guided what the Fed’s done in these markets, very, very successfully, in the commercial paper financing facility and a range of other facilities you saw the Fed design over the last six to 12 months.

In response to a question about the interest rate that will be charged on government financing for the P-PIF

The second step toward strengthening the credibility of our commitment to sound monetary policy is to clarify the criteria under which we choose to step in as a lender of last resort. We must spell out when we will intervene in markets or extend unusual credit to firms — and then we must be willing to stick to those criteria. Moreover, we also need to complement such clear commitment with a well-articulated exit strategy from such liquidity or credit programs.

Our lending programs were created for extraordinary times and involve significant intervention in the private markets, but they run contrary to a long-standing and sound Fed practice of trying to minimize the effect of its actions on the allocation of credit across market segments. In my view, such programs are not, and should not, be part of the normal operation of a central bank.

It is very important to note that the largest components of the expansion of the Federal Reserve balance sheet are likely to become unappealing to market participants as financial conditions improve and interest rate spreads decline.  Thus, much of the Fed’s balance-sheet expansion should be reversed as we see the return of more normal trading.

...

(T)he Federal Reserve programs I have described today are intended to reduce the unusually large spreads created by financial disruptions, so that the cost of credit for a variety of borrowers returns to the level we would expect with more normalized functioning of credit markets.  The Federal Reserve’s recent monetary policy actions, combined with the fiscal stimulus package that the government recently enacted, should in my view help pull the economy out of the severe recession we have been experiencing.