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FACTBOX: Federal Reserve exit strategy tools

(Reuters) - Federal Reserve Chairman Ben Bernanke, in the U.S. central bank’s monetary policy report to Congress on Tuesday, provided more details on the tactics the central bank may use to eventually withdraw its monetary stimulus.

The Fed’s balance sheet has ballooned above $2 trillion during the crisis through temporary liquidity programs and longer-term asset purchases. As the economy recovers, the Fed will have to ensure that inflation does not result.

Bernanke said reserves held by banks at the Fed will to some extent contract automatically. Improving financial conditions have already led to the short-term lending facilities being used less and will eventually lead to their being wound down.

Redemptions of the Fed’s holdings of agency debt, agency MBS and longer-term Treasury securities are expected to occur at a rate of $100 billion to $200 billion each year over the next few years, Bernanke wrote in the monetary policy report.

“Despite continued large holdings of assets, the Federal Reserve will have at its disposal two broad means of tightening monetary policy at the appropriate time,” he wrote.

“In principle, either of these methods would suffice to raise short-term interest rates; however, to ensure effectiveness, the two methods will most likely be used in combination,” he wrote.

Below are some of the Fed’s exit strategy options outlined in the report to Congress -- alongside some drawbacks discussed by analysts:

PAYING INTEREST ON RESERVES:

By setting the interest rate on reserves the Fed essentially creates a magnet for banks to place those reserves with the Fed rather than lend them out into the financial system -- creating a floor under short-term market rates.

This is because banks generally will not lend funds in the money market at a rate lower than they can earn risk-free at the Fed.

“Raising the interest rate paid on balances that banks hold at the Federal Reserve should provide a powerful upward influence on short-term market interest rates, including the federal funds rate, without the need to drain reserve balances,” Bernanke wrote.

A number of central banks around the world have effectively used this tool.

Cons: There could be a political backlash if the Fed was paying banks a significant amount of taxpayer money to push up interest rates. “That payment is perfectly logical from a monetary policy perspective, but it is a disaster from a public relations perspective,” according to Bank of America-Merrill Lynch research.

LARGE SCALE REVERSE REPURCHASE AGREEMENTS:

The Fed could arrange large-scale reverse repurchase agreements, or repos, with financial market participants, which would drain reserves from the banking system and reduce excess liquidity at other institutions.

Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Con:

Large-scale repos could inflate dealer balance sheets as dealers relend the collateral from the Fed to money market funds, wrote Bank of America-Merrill Lynch analysts.

TREASURY SUPPLEMENTARY FINANCING PROGRAM:

The Fed could take in more cash from the Treasury through the Supplementary Financing Program. Last fall, the Treasury raised almost $560 billion by issuing SPF bills and held the funds on deposit at the New York Fed to offset part of the ramp up in the Fed’s balance sheet at the time. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

Cons: This program could push the Treasury quickly toward the congressionally set limit for federal debt. In addition, the bills would increase the Treasury’s financing needs at a time of record budget deficits and could fuel the perception that the Fed and the Treasury are not operating independently of each other.

“One limitation on this option is that the associated Treasury debt is subject to the statutory debt ceiling. Also, to preserve monetary policy independence, the Federal Reserve must ensure that it can achieve its policy objectives without reliance on the Treasury if necessary,” Bernanke wrote in the report.

TERM DEPOSIT FACILITY:

The Fed could create a new “term deposit facility” for banks, similar to certificates of deposits (CDS) that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the fed funds market, he said.

“Such deposits would pay interest but would not have the liquidity and transactions features of reserve balances. Term deposits could not be counted toward reserve requirements, nor could they be used to avoid overnight overdraft penalties in reserve accounts,” Bernanke wrote.

ASSET SALES:

The Fed could sell a portion of its holdings of longer-term securities into the open market, Bernanke said.

Cons:

Large-scale selling of Treasury securities could disrupt markets and potentially hamper the Treasury’s ability to issue new debt, analysts said.

The Fed is likely to be very cautious about selling its agency mortgage-related assets for fear of distorting those less-liquid markets.

SOME POTENTIAL TOOLS BERNANKE DID NOT MENTION:

FED BILLS:

Other central banks such as the European Central Bank have the authority to issue their own debt as a way to drain reserves.

Cons: The Fed would need congressional authorization and lawmakers, already uneasy about huge bank bailouts, are unlikely to be keen on granting the Fed more powers. Fed borrowing would also compete with Treasury borrowing during a wave of government debt issuance.

RAISE RESERVE REQUIREMENTS:

The Fed cut reserve requirements in the early 1990s to make banks more competitive with the shadow banking system and could raise them again. By boosting reserve requirements dramatically, the Fed could fuel enough demand to create a working federal funds market even at high levels of reserves.

Cons: It would be an effective tax on the banking system and could make banks less competitive versus non-banks.

“This would be a last-ditch option, as reserve requirements have long been viewed as too blunt a policy tool,” said Ed McKelvey, an economist at Goldman Sachs.

Sources: Research by Goldman Sachs, JPMorgan, Wrightson ICAP, Bank of America-Merrill Lynch

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