The Exit Strategy, Again

According to the WSJ, Ben Bernanke is expected to outline the Federal Reserve’s exit strategy this week. As expected (and discussed previously), the Fed plans to tighten monetary policy by increasing the interest rate on excess reserves. Otherwise, as the economy recovers and the excess reserve ratio declines, the money multiplier would rise and thus broader aggregates would rise as well. Given that there are currently over $1 trillion of excess reserves in the system, a failure of policy to tighten when the money multiplier begins to rise would result in rapidly increasing prices.

As I previously discussed, the interest on reserves methodology is a rather crude way to solve the problem. If the problem is with excess reserves, then the reserves should be removed from the system using normal open market operations. So why isn’t the Fed employing this method? Well, I have long suspected that the reason the Fed was employing this strategy was because of the change in the composition in the Fed’s balance sheet away from traditional Treasury holdings and toward mortgage backed securities. This view is confirmed in the WSJ:

Plans for the Fed’s portfolio of mortgage-backed securities are another element of the internal debate over the exit strategy from super-cheap money. The Fed is on course to buy up to $1.25 trillion of the securities, in an effort to hold down mortgage rates and buoy housing.

Over time, officials want to reduce these holdings and return to holding U.S. Treasury securities as the Fed’s primary asset. But they are reluctant to take steps that might push mortgage rates higher and damage the still-fragile housing market. Eventually, they could gradually sell mortgage securities, but such a move would be unlikely in the early stages of tightening.

So, ultimately, the Fed is conducting fiscal policy by subsidizing mortgage rates. What’s more, given that open market operations would necessarily require not only open market sales of Treasury securities, but also mortgage backed securities, the Fed finds itself in a position in which open market operations are politically and practically infeasible.