Yesterday, the Federal Reserve announced it would begin testing a way to reduce its large portfolio of mortgage-backed securities (MBS). It had previously said that it would purchase MBS through next March. The Fed is emphatically stating that this plan isn't changing and that this test doesn't signal anything about their exit strategy timing. Really, it's just a test. Still, I think even a test has significance.

The New York Times gets it right in its article about this test, when it says:

But the move did demonstrate that the Federal Reserve's preparations were becoming more concrete, and it highlighted the delicate task of bringing monetary policy back to normal without disrupting financial markets.

In short, the Fed means business. This test shows that it's moving forward with developing its exit strategy, so it really does intend to shrink its balance sheet when it feels the time is right. It's nice to see the Fed being proactive about ensuring that it knows how to reduce its assets while making as few waves in the market as possible.

So when can we expect the exit strategy to begin? If such action was very far off, then I'm not sure why the Fed would bother putting the details in place now. For example, would it prepare more than a year in advance? Probably not, unless it's just trying to prove to the market that it really has an exit strategy.

And that's the only way to interpret this test as dangerous -- if it really does imply exit strategy implementation is imminent. Although the Fed must have monetary tightening in the back of its mind, doing so too soon would debilitate the recovery. I'm unconvinced that its exit should begin in 2010, unless the next few quarters turn out to be much better than I expect.

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