A debate is bubbling away inside the Federal Reserve system as to how the US central bank should sequence, communicate and execute its eventual exit from unconventional monetary policy, the Financial Times reported.
The statement issued at the end of Wednesday's Fed policy meeting may not cast much light on this, beyond perhaps emphasising that the exit from unorthodox liquidity provision is already well advanced and can proceed independently from monetary policy.
But the central bank will have to flesh out its thinking as 2010 progresses. "The order in which the committee will chose to use its exit tools matters," says Larry Meyer, a former Fed governor.
At the heart of the exit sequence debate are five interlocking questions. Should the Fed focus on tightening short-term rates as normal or tightening long-term rates through asset sales?
Assuming the Fed focuses on short-term rates, does it need to reduce the more than $1,000 billion excess bank reserves substantially, early in the process and ideally before raising rates?
When it starts raising, should it communicate its policy stance in terms of an interest rate on bank reserves rather than a target for the Fed funds rate as in the past?
If it starts tightening without draining the excess reserves, will it have to move more aggressively than it would otherwise have done? And what is the end destination in terms of the monetary policy regime the Fed wants when the exit is complete?
The tentative answers from the Fed leadership appear to be respectively: yes, no, maybe, probably and something different from the pre-crisis regime.
But a number of Fed policymakers favour a different approach that would hew more closely to the Fed's pre-crisis way of doing business.
Since the start of the crisis in August 2007 the Fed balance sheet has more than doubled in size from $874 billion to $2,190 billion, with much of the increase financed by creating bank reserves.
In recent months loans to the financial system have declined sharply from $1,623 billion to $265 billion. But the Fed has continued to accumulate assets and reserves now stand at $1,107 billion - roughly 50 times the pre-crisis level.
Some economists think reserves play a special role in the creation of credit and the Fed must reduce reserves early in the exit process or risk excess inflation.
Jim Bullard, president of the St Louis Fed, proposes tightening policy by selling back Fed assets, which would raise long-term rates, while also reducing reserves, before raising short-term rates. But the Fed leadership views this as potentially risky, so it remains focused on tightening at the short end.
The central bank has tested tools - including reverse repo operations in which the Fed borrows money against some of its assets - that would allow it to drain reserves, potentially on a large scale, and replace them with other short-term liabilities.
But the Fed leadership does not think reserves have a unique role in the inflation process. So it will probably end up draining reserves only to the degree necessary to buttress its favoured new tool: the ability to pay interest on bank reserves and thereby put a floor under the Fed funds rate.
Such operations could be near-simultaneous with the first Fed rate rise and not provide advanced warning. "When I told audiences early on that they would see this coming well in advance, that actually doesn't have to be true," Charles Evans, president of the Chicago Fed, told the FT in a recent interview.
Once Fed tightening begins, officials see some logic in making the rate on bank reserves the main focus of communication, though market habit could force them to stick to the fed funds rate, which is expected to trade in a range near the reserves rate.
If the Fed does start tightening with more than a trillion of excess reserves in the banking system, senior Fed officials acknowledge that it may have to raise rates more rapidly than in a world in which banks had only $20 billion reserves.
Calibrating this will be difficult. Allan Meltzer, a professor at Carnegie Mellon, says when Fed officials tell him they will raise rates higher if necessary to offset swollen reserves, "I ask them how high? They don't know the answer."
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