Fed's exit toolkit comes without instruction manual

WASHINGTON (Reuters) - The Federal Reserve has the tools to withdraw the more than $1 trillion it has pumped into the financial system but it's not clear policymakers are exactly sure how to use them.

Figuring out where to set benchmark interest rates, the Fed's usual lever to conduct policy, is already a tough judgment call. Now, a new array of options ranging from withdrawing short-term capital to selling longer-dated assets has made the machinery of policy even more complex.

That means adequate calibration, already a delicate act for Fed officials, will become all the more tricky. Unorthodox measures will require an unconventional exit and the central bank will have to learn by doing, with all of the potential for market disruption -- and inflation -- this entails.

"There is going to be considerable event risk, simply because we're in uncharted terrain," said economist Joseph Brusuelas of Brusuelas Analytics.

Fed Chairman Ben Bernanke on Wednesday laid out his most detailed vision yet of the central bank's path away from extraordinary stimulus measures. Still, plenty of uncertainty remains surrounding the implementation of such steps.

Bernanke and others at the Fed's Washington-based Board of Governors favor using the interest the Fed is now allowed to pay on banks' excess reserves, in addition to reverse repurchase agreements and term deposits, to induce market participants to park short-term dollars at the central bank.

In a reverse repo, the Fed agrees to sell securities such as Treasury bonds to investors for a short period and then buy them back at a slightly higher rate at a later date, allowing it to remove some money out of circulation for a time. Term deposits would give banks the incentive to leave money at the Fed for longer periods, probably ranging from one to six months.

BIG UNKOWNS

However, some officials, especially regional bank presidents, are uncomfortable with the current composition of the central bank's balance sheet, particularly the increasing proportion of mortgage assets resulting from its ongoing purchase of $1.25 trillion in mortgage-linked bonds.

St. Louis Federal Reserve Bank President James Bullard told Reuters this week he would prefer to see the central bank begin to sell off assets before it raises interest rates -- perhaps as early as the second half of this year.

Richard Fisher, of the Dallas Fed, has been less explicit about his views on the sequencing of exit steps, but equally vocal about what he sees as the potential dangers of the Fed's asset purchases.

"We are constantly discussing internally the ways and means to shrink our balance sheet back to historical norms, aiming to have our holdings once again consisting primarily of Treasuries needed for the regular operations we undertake as the nation's central bank," Fisher said in a speech on Wednesday.

Investors also have their share of concerns.

Will attracting demand for term deposits be an issue, and would it strip demand for other short-term instruments like Treasury bills?

Will there be enough market demand for reserve draining operations, particularly from institutions like big money market funds that are flush enough with short-term cash to participate?

"That is one of the big unknowns," said Ian Lyngen, senior government bond trader at CRT Capital Group. "If the Fed is able to engineer the reverse repos in such a way that it can access money market mutual funds, that's going to allow them to really make strides in sopping up the excess liquidity."

Any failure of these tools could lead to a loss of confidence in the markets about the Fed's ability to retreat in a timely fashion. That could push up expectations of future inflation.

It might also complicate the Fed's ability to tighten financial conditions as it sees fit, and avoid an unwanted spike in inflation once the economy recovers more fully.