Longer-term issues

In response to the financial crisis, the Federal Reserve created a number of special lending facilities to stabilize the financial system and support economic activity. As market conditions and the economic outlook have improved, most of these programs have been terminated, and the Federal Reserve plans to phase out the rest over the next several months. The Federal Reserve also promoted economic recovery through sharp reductions in its target for the federal funds rate and through purchases of securities. At some point as the economic expansion matures, the Federal Reserve will need to tighten financial conditions in order to avoid a buildup of inflationary pressures.

The Federal Reserve's expanded balance sheet has left the banking system holding well over a trillion dollars of reserves. As a consequence, the Federal Reserve has been developing a number of tools to strengthen its control of short-term interest rates, importantly including new tools to reduce the large quantity of reserves held by the banking system.

The authority granted by the Congress for the Federal Reserve to pay interest on reserve balances beginning in October 2008 will be especially important in the process of removing policy accommodation. Increasing the interest rate on reserves should put significant upward pressure on all short-term interest rates, as banks generally will not lend funds at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks.

The Federal Reserve has been developing other new tools to drain large quantities of reserves, including reverse repurchase agreements (reverse repos) and term deposits. Reverse repos are transactions in which the Federal Reserve sells a security to a counterparty with an agreement to repurchase the security at some date in the future. The counterparty's payment to the Federal Reserve has the effect of draining reserves. As a second means of reducing reserves, the Federal Reserve has plans to offer term deposits to depository institutions. Funds in such term deposits would not be available to satisfy reserve requirements or clear payments and, as a result, would not count as reserve balances. Together, reverse repos and the term deposit facility would allow the Federal Reserve to drain substantial volumes of reserves from the banking system.

The Federal Reserve also has the option of redeeming or selling securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Federal Reserve's balance sheet.

The Federal Reserve is allowing agency debt and mortgage-backed securities (MBS) to run off as they mature or are prepaid, which results in a shrinking of the Federal Reserve’s balance sheet and a reduction in reserve balances. In the long run, the Federal Reserve anticipates that the size of its balance sheet will return to more normal levels and that most or all of its security holdings will be Treasury securities. At some point, the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the Federal Open Market Committee (FOMC) has determined that the associated financial tightening is warranted. Any such sales of securities would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions.

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