The central bank may suddenly and aggressively begin to shrink the money supply, once the timing is right

660 money print REUTERS Jeff Mitchell US.jpg

Just what exactly does the Fed mean by an "extended period," and what strategies does it apply to? After the Federal Open Market Committee's statement and new economic projections were released, Federal Reserve Chairman Ben Bernanke helped to clarify the Fed's language during his second post-meeting press conference on Wednesday. While the specific exit timing remains a mystery, we now have a better idea of what the Fed is thinking about the its strategy.

First, a bit of background will help here. The Federal Reserve has taken a number of extraordinary measures since the financial crisis to attempt to stabilize the market and accelerate the recovery. To simplify things, it purchased lots of assets and has kept interest rates near zero. At some point, however, it will need to sell most of those assets and raise interest rates in order to avoid inflation. But when will it do so?

The Fed has been vague on its timing. For interest rates, it has consistently indicated that they will be kept very low "for an extended period." But it hasn't made the same assertion about its gigantic portfolio. At this point, we just know that it's continuing to reinvest maturing assets so that the size of its portfolio remains constant.

In the presser, Jon Hilsenrath of the Wall Street Journal asked whether the "extended period" language applies to the Fed's portfolio holdings. Here's Bernanke's reply:

We haven't made any such commitment. It's true that when we begin to allow the portfolio to run off, rather than reinvesting, that would be a first step in a process of exiting from our currently highly accommodative policies. But we have not yet chosen to make any commitment about the time frame. But we'll be looking at the outlook and trying to assess when the appropriate time is to take that step.

In the FOMC's April meeting minutes, we learned ending reinvestment will be the fist step in exit, so this isn't really news. But it is worth noting that Bernanke does not want to apply the "extended period" language to the time for which the size of the Fed's portfolio will remain stable. This implies that the Fed wants significant flexibility for when it decides to begin allowing its portfolio to run off. This point is accentuated by considering another question posed later in the presser.

Peter Barnes asked what appeared to be a stupid question -- because it was one to which Bernanke surely wouldn't a straight answer. Barnes wanted to know how long the "extended period" could be expected to last. If the Fed wants us to know that, then they would have told us. But Bernanke's response was somewhat revealing:

We don't know exactly how long. I think the thrust of extended period is that we believe we're at least two or three meetings away from taking any further action, and I emphasize "at least." But depending on how the economy evolves and inflation and unemployment, it could be significantly longer. It depends how the economy and economic outlook changes. If we do get both improved job creation and inflation close to or even above our mandate consistent level, then that would be a sign that we need to consider beginning an exit process. But we are not there at this point.

We shouldn't take his mention of "at least two or three meetings" to mean that interest rates could rise at the end of this year. They almost certainly won't. But Bernanke does admit that its near-zero interest rate policy could change pretty quickly, if the recovery suddenly hastens.

You can imagine what will happen here once the U.S. economy begins to heal at a more rapid pace. The Fed will drop the "extended period" language in one meeting. Then as soon as a meeting or two later, it will raise interest rates. The market might not have six to eight months to prepare for higher interest rates once the "extended period" language is dropped.

In other words, at some point "an extended period" might not be very long at all. This also implies that the Fed could, at some point, decide to allow maturing assets to run off rather abruptly. If it could give markets as little as two to three months notice that it's raising interest rates, then it would likely provide even less notice that it's ending its reinvestment policy.

None of that is likely to happen for the time being, however. The economy has hit a soft patch and the Fed will certainly not risk further aggravating the problem by beginning its exit too soon. But if the shocks that caused the slowdown begin to dissipate and job growth begins to accelerate at a rate faster than we saw earlier this year, then the Fed could quickly begin its exit strategy.

Image Credit: REUTERS/Jeff Mitchell US

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