The Fed could ask to swap longer-term Treasury debt for short-term bills and notes, thus reducing the maturity of its portfolio to accelerate the runoff. The Fed and Treasury could do this partly in a one-time swap, and partly by allowing the Fed to bid on new issues and pay with its holdings of long-term Treasuries, Crandall said.
Because the Fed would have less debt to sell to return its portfolio to a normal size, it could be “more aggressive in the liquidation” of housing-agency securities, he said, which was a priority for Fed officials when they announced the exit strategy.
Asset purchases have made it harder to change the federal funds rate when the time comes to raise borrowing costs.
In the five years before the crisis, excess bank reserves averaged $1.7 billion, so the Fed could alter interest rates by buying or selling comparatively small amounts of short-term debt in open-market operations.
Those reserves are now more than 800 times larger at $1.4 trillion. To move the fed funds rate, the central bank will have to drain or lock up the supply of excess reserves.
Under the current exit plan, the Fed would soak up reserves by using reverse repurchase agreements or offering term deposits.
“I’m not sure we’ll really know, until they undertake a real program, what the effectiveness is” of such measures, said Bank of America’s Hanson. “The amount of reserves could be so large that the draining doesn’t do a whole lot.”
The central bank could lose credibility if its policy actions don’t move the federal funds rate, said Marvin Goodfriend, a former adviser at the Richmond Fed.
“The Fed needs to delicately acquire inflation credibility in the exit,” said Goodfriend, a professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh. “We are used to tightly managed short-term interest rates.”
The Fed’s other tool is to extinguish reserves by selling bonds back to dealers. Even a fully-explained plan could push up home borrowing costs as traders account for hundreds of billions of dollars of new supply flowing back into the market.
“We are deep into experimentation at this point,” Oliner said. “It’s understandable that people are worried.”
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