Fed's Brian Sack: "The Fed Will Be Embarking On A Tightening Cycle Like No Other In Its History"

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From Brian P.
, Executive Vice President. Recall that Brian is the de-facto head of the Fed's "markets group" operation located on the 9th Floor of Liberty 33. If there is indeed a Plunge Protection Team, Brian is likely the PM who runs it.

Remarks at the National Association for Business Economics Policy Conference, Arlington, Virginia

you for inviting me to speak today. In my remarks, I will provide an
update on the progress that the Federal Reserve is making toward
preparing for a smooth exit from the extraordinary policy actions that
were taken in response to the financial crisis.1

I should note up front that I will not be providing any information
about the likely timing of policy tightening; those decisions will be
made and communicated by the Federal Open Market Committee (FOMC).
Instead, I will focus my comments on the policy tools and strategy that
are likely to be used whenever that exit becomes appropriate. I will
also discuss the preparedness of financial markets for the Fed's exit,
in order to assess how financial conditions may evolve as the exit
approaches and gets under way.

When the time comes to tighten monetary policy, the Federal Reserve
will be embarking on a tightening cycle like no other in its history.
First, this tightening cycle will have two policy dimensions, in that
the FOMC will have to decide on the path of its asset holdings in
addition to the path of the short-term interest rate. Second, we will
be using tools to drain reserves that are new and that will have to be
implemented on a scale that the Fed has never before tried. And third,
we will be operating in a framework of interest on reserves that has
not been fully tested in U.S. markets.

All of that may sound risky. However, I believe the Federal Reserve is
positioned to minimize any risks involved. Most important, we have
worked hard to ensure that we have all of the tools needed to exit, and
FOMC members have begun to describe a strategy for using them that is
cautious along several dimensions. In addition, if we communicate
effectively, the markets should be clearly informed and well prepared
ahead of the exit. These are the points that I will emphasize in more

Liquidity Facilities: A Success Story
When discussing the Federal Reserve's exit strategy, it is important to
separate liquidity facilities from the stance of monetary policy. While
the exit from the accommodative monetary policy stance has yet to
begin, the exit from liquidity facilities is nearly complete. Let me
begin with some comments on recent developments regarding the liquidity
facilities, and then I will move on to monetary policy.

As is well known, the Federal Reserve launched a number of liquidity
facilities to provide short-term funding to the financial markets
during the crisis, in order to meet the extraordinary demand for
liquidity at that time. Here I am referring to those facilities that
provided funding at maturities of up to three months to particular sets
of firms, such as the primary dealers, money market mutual funds,
commercial paper issuers, and depository institutions.2
Just today, we conducted the last operation associated with those
facilities, meaning that all of the short-term liquidity facilities
that were introduced during the crisis have now effectively been
retired. The only special liquidity program that remains active is the
Term Asset-Backed Securities Loan Facility, which I consider to differ
from the short-term liquidity programs because it provides funding for
up to five years.

With the wind-down of these short-term liquidity facilities, it is a
good time to look back and assess their performance. The bottom line
here is simple: These programs were an unquestionable success. We have
witnessed a remarkable improvement in the functioning of short-term
credit markets and an impressive recovery in the stability of large
financial firms. While a whole range of government actions contributed
to this recovery, giving financial institutions greater confidence
about their access to funding, and that of their counterparties, was
most likely a crucial step toward achieving stability.

Moreover, the exit from these facilities has been quite smooth. At
their peak, these facilities provided more than $1.5 trillion of credit
to the economy. Today, the remaining balance across them is around $20
billion. It is impressive that the Fed was able to remove itself from
such a large amount of credit extension without creating any
significant problems for financial markets or institutions. That
success largely reflects the effective design of those programs, as
most were structured to provide credit under terms that would be less
and less appealing as markets renormalized. This design worked
incredibly well, as activity in most of the facilities gradually
declined to near zero, allowing the Fed to simply turn them off with no
market disruption.

The success of these facilities should be judged by the outcomes they
produced for financial market functioning, and not by the financial
returns they generated on the Federal Reserve's books. However, there
are several reasons why the Fed might be expected to profit from this
type of lending under most circumstances. First, the Fed is providing
funds in response to an extreme move in the price of liquidity—that is,
it is in effect buying a cheap asset. Second, the programs themselves,
if successful at returning market functioning, would help the
performance of the Fed's loans to be sound. And third, the lending
under these facilities has to be adequately secured.

Asset Holdings: A Policy Lever
While the exit from the liquidity facilities has been successful, the
exit from the accommodative stance of monetary policy involves a
different set of challenges. Many of these challenges arise from the
Federal Reserve's outright holdings of Treasury debt, agency debt and
agency mortgage-backed securities (MBS), which together represent the
overwhelming share of the Fed's balance sheet today. Indeed, as a
result of our large-scale asset purchase programs, these asset holdings
now account for $2.0 trillion of the Fed's $2.3 trillion balance sheet.

The Federal Reserve is approaching the scheduled end of its large-scale
asset purchases. We have bought $169 billion of agency debt to date,
nearly fulfilling our plan to purchase "about $175 billion." For MBS,
we have only about $30 billion of purchases remaining to reach our
$1.25 trillion target. In addition, we completed $300 billion of
purchases of Treasury securities late last year. Looking across these
programs, we have now purchased $1.69 trillion of assets, bringing us
98 percent of the way through our scheduled purchases. To get to this
point, the Trading Desk at the New York Fed has so far conducted 126
discrete operations to purchase Treasury and agency debt, and has
managed 292 trading days on which either it or its investment managers
have acquired MBS.

My view is that the purchase programs have helped to hold down
longer-term interest rates, thereby supporting economic activity. With
the conclusion of the programs approaching, the Desk has been tapering
the pace of its purchases of agency debt and MBS. However, even as the
pace of our purchases has slowed, longer-term interest rates have
remained low, and MBS spreads over Treasury yields have remained tight.
This pattern suggests that the effects of the purchases have been
primarily associated with the stock of the Fed's holdings rather than
with the flow of its purchases. In that case, the market effects of the
purchase program will only slowly unwind as the balance sheet shrinks
gradually over time.3

In my previous speech back in December, I discussed in detail the
channels through which these market effects may arise. By removing
large amounts of duration and prepayment risk from the market, the
Fed's asset purchases reduced the volume of risk that the market had to
hold, which lowered the risk premia on those assets. Put differently,
the purchases bid up the prices of those assets and hence lowered their
yields. The lower levels of yields would be expected to boost other
asset prices as investors substitute into alternative asset classes.
These patterns describe what researchers often refer to as portfolio
balance effects.

Such effects are important to consider, because they have implications
for monetary policy. If the Fed's holdings of assets have produced
lower long-term interest rates, the FOMC has to carefully take into
consideration how it will manage the size of its balance sheet going
forward. In particular, a rapid and substantial reduction in our
holdings of assets would likely push up long-term interest rates that
is, it would put upward pressure on those rates by unwinding the
portfolio balance effect. That increase in long rates would, in turn,
weigh on other asset prices, reversing the positive effects that had
been associated with the expansion of the Fed's balance sheet.

Under this view, the size of the Fed's asset holdings becomes a
relevant policy lever. Accordingly, this will be the first tightening
cycle for which there are two broad policy decisions in play, as the
FOMC will have to set out not only the path of the short-term interest
rate, but also the path of its asset holdings. The decisions on these
two variables will have to be made in conjunction with one another to
produce the desired outcome for economic activity and inflation.

These considerations leave open a range of outcomes for how the two
instruments will be used. In his February 10 testimony, Chairman
Bernanke described a possible approach for managing the size of the
balance sheet. In particular, he indicated that he does not currently
anticipate that the Fed will sell any of its asset holdings until the
economic recovery is more firmly established and policy tightening has
gotten underway. Until that time, the portfolio would shrink only
through asset redemptions. Chairman Bernanke noted that the Fed's
holdings of agency debt and MBS are being allowed to roll off the
balance sheet, without reinvestment, as those securities mature or are
prepaid, and that the FOMC may choose to redeem some of its holdings of
Treasury securities in the future, as well.

With this approach, the FOMC would be shrinking its balance sheet in a
gradual and passive manner. That, in my view, is a crucial message for
the markets. It should limit any reversal of the portfolio balance
effects described earlier, effectively putting reductions in asset
holdings in the background for now as a policy instrument. As long as
this approach is maintained, it would leave the adjustment of
short-term interest rates as the more active policy instrument—the one
that would carry the bulk of the work in tightening financial
conditions when appropriate.

This approach is cautious in several dimensions. First, a decision to
shrink the balance sheet more aggressively could be disruptive to
market functioning. Second, a more aggressive approach would risk an
immediate and substantial rise in longer-term yields that, at this
time, would be counterproductive for achieving the FOMC's objectives.
Third, the effects of swings in the balance sheet on the economy are
difficult to calibrate and subject to considerable uncertainty, given
our limited history with this policy tool. And fourth, policymakers do
not need to use this tool to tighten financial conditions. They can
tighten financial conditions as much as needed by raising short-term
interest rates, offsetting any lingering portfolio balance effects
arising from the still-elevated portfolio.

Even under this cautious strategy of relying only on redemptions, the
Federal Reserve could achieve a considerable decline in the size of its
balance sheet over time. From now to the end of 2011, we project that
more than $200 billion of the agency debt and MBS held by the Federal
Reserve will mature or be prepaid, though the actual total will depend
on the path of long-term interest rates and the prepayment behavior of
mortgage holders. Thus, the Fed's asset holdings would shrink
meaningfully if the FOMC maintains its current strategy of not
reinvesting those proceeds. In addition, about $140 billion of Treasury
securities mature between now and the end of 2011, giving the FOMC
scope to reduce its asset holdings even further if it chooses to not
replace some of those maturing securities.

While the passive strategy of relying on redemptions may be appropriate
for now, it might not be sufficient over the longer-term. One problem
is that relying only on redemptions would still leave some MBS holdings
on our balance sheet for several decades. As indicated in the minutes
from the January meeting, the FOMC intends to return to a
Treasuries-only portfolio over time. This consideration could motivate
the FOMC to sell its agency debt and mortgage-backed securities at some
point, once the economic recovery has progressed sufficiently.

Draining Tools: Control of Short-Term Rates
Under the strategies just described, the Fed's asset holdings are
likely to still be elevated at the time that the FOMC wants to raise
short-term interest rates. That creates a challenge for controlling
those rates, because of the large amounts of reserves that were created
from the Fed's purchases of those assets. It is therefore important for
the Fed to determine the way in which it will raise short-term interest
rates in an environment with so much
liquidity—a topic that I will now cover.

The primary vehicle for making adjustments to short-term interest rates
in that environment is the ability to pay interest on reserves. We
would expect changes in the interest rate on reserves to have a
significant influence on other short-term interest rates. However, in
order to ensure our ability to influence those other short-term
interest rates, we have been developing two tools that can be used to
reduce the large amount of excess reserves in the banking system—term
deposits with banks and reverse repurchase agreements (reverse repos)
with a broader universe of financial institutions. Let me first provide
an update on the progress we have made in developing these tools.

On term deposits, the Federal Reserve has received public comments on
the proposed structure of the facility that was published in December,
and we are working toward its final form. As described in the recent
Monetary Policy Report, the Federal Reserve expects to be able to
conduct test transactions in the spring and to have the facility fully
ready, shortly thereafter, to conduct transactions when needed.

On reverse repos, we have already successfully run small-scale
operations using Treasury and agency debt as collateral with primary
dealers. However, that leaves two significant steps still to take in
preparing the tool. One is developing the capacity to use our MBS
holdings as collateral. Work in that area is nearly complete, and we
will likely conduct some small-scale operations with MBS collateral in
a month or so to exercise that capability. The other step is expanding
the set of counterparties that we use for such operations. Earlier
today, we published criteria for money market mutual funds to become
eligible to participate in reverse repo operations, which was a first
and important step in that direction. We are currently working with
other types of firms to assess their potential participation in the
program, as well. Our expectation is to have arrangements in place and
to be ready to transact with some non-dealer firms by the end of the
second quarter. This expansion of counterparties is important for
boosting the capacity of the program.

The bottom line is that the preparation of both facilities is advancing
very effectively. Looking across the two programs, we will have
established the capacity to drain a significant portion of excess
reserves by the second half of the year. Of course, achieving this
capacity does not say anything about how and when the FOMC will decide
to actually drain reserves.

The actual timing and size of draining operations, and their relation
to changes in the interest rate paid on reserves, will depend on how
market and economic conditions evolve. Chairman Bernanke discussed one
possible sequence in his February 10 testimony. He suggested that
operations to drain reserves could be run on a limited basis well ahead
of policy tightening, in order to give market participants time to
become familiar with them, and then could be scaled up to more
significant volume as we approach the time for policy tightening.

Removing a portion of the excess reserves from the system ahead of
increasing the rate paid on reserves is a cautious approach, as it
should improve the Fed's control of short-term interest rates when it
comes time to tighten monetary policy.4
To be sure, even at today's reserve levels, we would expect the
interest rate paid on excess reserves to exert considerable pull on
other short-term interest rates such as the federal funds rate or repo
rates. However, we are unsure of the exact relationship between these
rates and believe that it is likely to be tighter when the banking
system is not as saturated with liquidity as it is today. Thus, it may
be prudent to remove some portion of excess reserves before raising the
interest rate on reserves.

Note that the policy tightening in this scenario will still likely be
taking place in an environment of large excess reserve balances, and
the main workhorse of the tightening cycle will still be the interest
paid on reserves. However, the draining tools can be used to best
ensure the success of that framework.

Market Conditions: At Risk on Exit?
Finally, let me turn to conditions in financial markets and discuss
whether there may be vulnerabilities related to the Fed's exit from the
current monetary policy stance. I think there are two potential areas
of concern.

The first potential concern is that the exit strategy could simply
cause confusion among market participants, prompting volatility in
asset prices. As noted earlier, this tightening cycle, when it arrives,
will be more complicated than past cycles, as there will be more
decision points facing policymakers. With more decision points come
more opportunities for the markets to be confused by our actions. The
recent changes to the discount rate and the Treasury's Supplementary
Financing Program balances highlight this concern, as the amount of
attention that those actions received was outsized relative to their
significance for the economy or for the path of short-term interest

The burden is on the Fed to mitigate this risk by communicating clearly
about its policy intentions and the purpose of any operational moves it
might take. In this regard, the forward-looking policy language that
the FOMC is currently using in its statement is important. I would
argue that this language contains much more direct and valuable
information about the likely path of the short-term interest rate
target than does any decision about draining reserves. Indeed, it will
be difficult for market participants to make precise inferences about
the timing of increases in the target interest rate from the patterns
of reserve draining alone, in part because the FOMC has not specified
the path of reserves it intends to achieve before raising interest

The second potential concern that some may have is whether the markets
have adequately priced in the exit strategy. However, a few
considerations should limit this concern. Most important, the current
configuration of yields and asset prices incorporates expectations that
short-term interest rates will begin to rise around the end of this
year. Thus, the markets seem prepared for the risks toward tighter
policy. Moreover, looking out to longer maturities, the shape of the
Treasury yield curve appears to incorporate not only expectations of
policy tightening, but a decent-sized term premium on longer-term
securities. Indeed, the term premium is well above the levels observed
over most of the past several years, even though inflation is likely to
be low and upside inflation risks are limited. This should help to
diminish the chances of a sizable upward shift in yields.

A related issue is whether the current levels of risky asset prices
will prove robust in a rising rate environment. This may be a
particular concern among those who argue that the current low policy
rate environment has fueled an unsustainable rise in asset prices
beyond their fundamental values. However, this is not clearly the case
on a broad basis. Obviously, risky asset prices have undergone a
historic rise from their trough in early 2009. But this rise began from
an extreme starting point, one in which asset prices were being
depressed by the baseline forecast of a deep recession, by the prospect
of further downside risks to the economy, and by very elevated risk

As the economy stabilized, asset prices benefitted from both the
improving economic outlook and a significant renormalization of risk
premiums—a pattern that was a desired outcome from the stance of
monetary policy. Moreover, we do not see definitive signs that risk
premiums have broadly become too low at this point. To be sure, a
number of significant risks remain in the economic outlook, and those
translate into financial market risks. Eventually, though, we expect to
reach a period of sustained, above-trend growth to absorb the
substantial slack in place, which is an environment that should be
quite supportive of risky asset prices. Policy tightening will
presumably occur as that happens, limiting the downside risk to markets
associated with policy actions.

In conclusion, the exit from the various liquidity facilities that the
Federal Reserve implemented has been very successful, as the up-front
design of those facilities reduced the need to actively manage the end
of those programs. However, the exit from the current stance of
monetary policy is quite different, in that it will have to be actively
managed to ensure a smooth exit.

I began the speech by noting that we face an extraordinary challenge
with this exit, given the historic steps that have been taken with the
Fed's balance sheet. This challenge, which involves operating in
uncharted territory along several dimensions, will inherently involve
some uncertainties and risks. However, as I hope is clear from my
remarks, the Federal Reserve's efforts to date should minimize those
risks. Indeed, I believe the Fed's efforts have been prudent along a
number of dimensions.

As a first step, we have been careful to make sure we have an adequate
set of tools. To that end, we have developed multiple tools that can be
used for draining reserves, in order to ensure our capability to do so.
Moreover, we have been testing those tools and will continue to take
steps to ensure that we and the markets are prepared to use them in
more significant volumes when needed. Developing the tools is not
enough, though. As a second step, policymakers will need to formulate a
strategy for using them in an appropriate manner to avoid any undesired
outcomes for financial markets and the economy.

The FOMC is actively engaged in determining that strategy, as indicated
in the FOMC minutes from the January meeting. The strategy to be
employed has not been fully decided, but recent speeches by FOMC
members and the recent FOMC minutes have begun to convey some of the
possibilities. Many of the potential steps described seem to guard
against the risks involved. For example, reducing the size of the Fed's
balance sheet through redemptions for now will produce a gradual
adjustment that will be easier for the markets to digest. In addition,
steps taken to drain reserves ahead of policy tightening may best
ensure the success of interest on reserves at influencing other
short-term interest rates.

Overall, an approach along these lines should help to ensure a smooth
exit from the current accommodative stance of monetary policy.
Moreover, if the Fed's intentions are well communicated to the
financial market participants, they too should be fully prepared and in
the best possible shape for navigating this exit.


The views expressed here are not necessarily shared by the Federal Open
Market Committee or by other members of the staff of the Federal
Reserve Bank of New York.
2 In discussing these
facilities, I am not including any provision of credit intended to
support specific institutions, including those associated with the
Maiden Lane LLCs. I include the Term Securities Lending Facility in
with short-term lending facilities, even though it provided the market
with Treasury securities rather than reserves, because it was often
used to find funding for positions in less liquid securities.
An alternative explanation is that the large-scale asset purchases have
had no effect and that the low levels of rates and spreads simply
reflect other factors. However, I believe the evidence indicates that
the asset purchases have contributed to the low level of longer-term
4 Some have discussed whether the draining of
excess reserves has effects on the economy beyond the implications for
short-term interest rates. In my view, it would be surprising if there
were significant effects on the real economy or inflation associated
with substituting one short-term, liquid, risk-free asset (reverse
repos or term deposits with the Fed) for another (reserves), except for
the degree to which that substitution affects the Fed's control of
overnight interest rates.