The Global Radar Screen – 04/29/11

Posted May 2, 2011 by CLeahey

[private][private]Overview—The Fed Exit Sequence Coming Into View
While the first-ever FOMC press conference was more historic than newsworthy, we learned enough to get a better idea of the potential Fed exit sequence. As in 2010, the first time they tried, the Fed needs to do three things before they actually hike policy rates. First, the FOMC will alter the policy language, most notably the “extended period” sentence in the policy statement. Bernanke suggested that this phrase means the Fed would not hike rates until at least a couple of meetings had followed the announcement. Second, establish a corridor system, in which the federal funds rate trades within the floor of the interest rate on excess reserves (IOER) and the ceiling of the discount rate. They will use some combination of system RP operations to drain reserves and the auction of time reserve deposits (TDF) to push the funds rate, which drifted to 0.10% recently back to well above the IOER’s 0.25%. Third, shrink the balance sheet both passively by stopping reinvestment of the proceeds of maturing securities and actively by selling assets in the open market. No one, not even Bernanke, is sure of the timing, as it is conditional of the state of play of the economy. We would think that a possible sequence would suggest that the Fed would stabilize the balance sheet this summer after it peaks in June and then sometime in Q4 would passively shrink the balance sheet (as Bernanke hinted at the press conference), perhaps in conjunction with draining reserves enough to establish the funds rate corridor and some tinkering with the “low for long” language. At some time in early 2012, we think policy rates could be hiked (first hike 25 bps) about the time the Fed will undertake the first test of asset sales. Major security sales “in size” would follow, with a likely emphasis to returning to a “Treasuries-only” portfolio.
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