Fed's Monetary Stimulus Won't Completely End in June

Even if its $600 billion purchase program expires, it will continue to buy Treasury securities at an elevated pace

The Fed might be pushing the U.S. economy out of its monetary stimulus wheelchair in June, but the central bank won't likely force it to walk on its own: the Fed will still continue to provide a set of crutches. Even when it ends its $600 billion asset purchase program in a few months, it will likely continue to reinvest its portfolio's maturing assets by buying Treasury securities, which will still provide some support to the economy. So the Fed isn't really exiting yet: its balance sheet will remain static until it ends its reinvestment policy.

If the Fed's $600 billion quantitative easing strategy is called "QE2", then its reinvestment strategy could be called "QE1.5." Scott Lanman at Bloomberg addressed this program in an article on Tuesday, quoting JPMorgan Funds analyst David Kelly on why the Fed isn't likely to end QE1.5 in June:

Ending the reinvestment policy and the $600 billion program at the same time would be like quitting stimulus "cold turkey," said Kelly, who is based in New York and helps oversee $400 billion as chief market strategist at JPMorgan. "It does make sense to reinvest for a while," he said. "Then they could watch how bond yields react to that."

In fact, there's a big difference between the three scenarios before the Fed. One option would be to keep QE2 going after June, continuing to grow the Fed's balance sheet. The second option would be to kill QE2, but keep QE1.5 intact, leaving the size of the Fed's balance sheet unchanged. The third option would be to kill QE1.5 as well, which would mark the beginning of the Fed's exit from monetary stimulus, as it would allow the central bank's balance sheet to begin to decline in size.

Currently, QE1.5 results in the Fed purchasing somewhere between $17 billion and $24 billion in Treasury securities per month to replace maturing assets. Obviously, this is less than the $75 billion average purchases that QE2 provided, but it's still a significant sum. The Fed will probably continue to replace its maturing assets indefinitely, even after June.

Other than the mere fact that keeping QE1.5 in place for a time is prudent monetary policy, why else might the Fed decide not to kill it along with QE2? In fact, the Fed has made no indication that it has any such plans to end its reinvesting. The minutes from its March Federal Open Market Committee meeting say:

Specifically, the Committee maintained its existing policy of reinvesting principal payments from its securities holdings and reaffirmed its intention to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.

The expiration explained there only applies to QE2. Up to now, the Fed has not signaled any desire to end its policy of reinvesting principal.

So when might the Fed start allowing its balance sheet to naturally shrink through its assets maturing without being replaced? That could be one of the very first steps we see as a part of its exit strategy. This would be a very passive action on the part of the Fed, because the Fed would essentially do nothing and money supply would slowly decline. When the Fed believes the economy is on more solid footing, you might see its reinvestment cease.