NEW YORK (MNI) – The following is an excerpt from remarks Thursday
by Federal Reserve Board Governor David Tarullo prepared for delivery to
the New York Community Bankers Conference:

In thinking about an exit strategy, it is important to distinguish
between two types of policies that the Federal Reserve adopted,
beginning in 2007 and continuing thereafter, beyond its sharp reductions
in the target for the federal funds rate. First, the Federal Reserve
created a number of liquidity programs, which provided well-secured,
mostly short-term credit to various parts of the financial system that
were under increasingly severe strains. Among these were the Term
Auction Facility (TAF), which auctioned short-term funds to banks; the
Primary Dealer Credit Facility, which served as a backstop liquidity
provider for securities firms; the Term Asset-Backed Securities Loan
Facility (TALF), which was designed to help revive the market for
asset-backed securities, and others.

Second, and separately, the Federal Open Market Committee (FOMC)
undertook largescale purchases of Treasury securities, agency
mortgage-backed securities, and agency debt. This unconventional
monetary policy action was taken because the FOMC, after having reduced
short-term interest rates nearly to zero, determined that the severity
of the economic downturn made additional stimulus necessary. In addition
to improving conditions in mortgage markets, these asset purchases
helped lower yields on long-term debt; they also substantially increased
the level of reserve balances that depository institutions held with
Federal Reserve Banks.

Thus, while reference is often made to a single exit strategy,
there are in fact two separate objectives: One is to terminate the
special liquidity facilities and otherwise normalize our activities as
liquidity provider of last resort when the exceptional stresses have
eased sufficiently. The other is to raise interest rates when warranted
by economic conditions. Historically, the Fed has affected the level of
short-term interest rates primarily by varying the supply of bank
reserves. However, as I just mentioned, the Feds asset purchases have
had the effect of putting an unusually high level of reserves into the
banking system. Thus, in order to tighten monetary policy, the Fed
cannot simply raise its target for the federal funds rate; it will have
to take other steps to ensure that interest rates actually increase.

The first objective has now been substantially achieved. Diminished
use of some of our special facilities followed the easing of liquidity
stresses in the relevant markets, and led naturally to our closing those
facilities. In other cases, we decided that liquidity conditions had
improved enough that further support was not warranted and that markets
should function on their own. Many of our liquidity facilities expired
in February, and last month we ended the TAF and most of the TALF. All
that now remains of the special liquidity facilities is the part of the
TALF for loans backed by newly issued commercial mortgage-backed
securities, which itself is scheduled to close on June 30.

We have also restored pre-crisis practice with respect to the
maximum maturity of discount window loans and have increased the rate on
such loans to 50 basis points over the rate we pay on reserve balances,
from the 25 basis point level that was put in place during the crisis. I
would emphasize that the winding down of our emergency liquidity
facilities and the normalization of the terms for discount window credit
were undertaken because the recovery in financial markets suggested that
they were no longer necessary. These changes were not expected to lead
to tighter financial conditions for households and businesses and they
did not signal any change in the outlook for the economy or for monetary
policy.

As I have indicated, the second objective will likely require some
innovative measures, insofar as, all else equal, the unusually high
level of reserve balances would undercut efforts to raise the federal
funds rate through conventional means. As Chairman Bernanke has detailed
in his speeches and Congressional testimony, we have a number of tools
that will allow us to accomplish this task at the appropriate time.1 The
most important instrument is likely to be increasing the interest rate
paid to banks on the reserves they hold with the Fed.

Raising this rate should itself tend to raise the federal funds
rate, because banks have little incentive to lend into the federal funds
market at rates below what they can earn risk-free at the Fed. The
efficacy of this instrument can be increased by draining reserves
through the use of a number of instruments, including reverse repurchase
agreements (reverse repos), term deposits for reserve balances, and, if
necessary, sales of assets on our balance sheet. Thus, unlike a monetary
policy action under more normal conditions, our eventual decision to
raise interest rates will require a determination of the mix and
sequencing of these policy tools, as well as the basic determination of
when monetary tightening is appropriate.

In recent months, the Federal Reserve has been evaluating the
likely effects of each of these tools. We have also successfully tested
our capacity to carry out reverse repo transactions and are expanding
the group of counterparties with which these transactions can be carried
out. We have also been working on the development of a term deposit
facility. These analytic and practical steps are obviously taking place
in preparation for a change in monetary policy.

But it is important to emphasize that the completion of preparatory
steps need not be followed in short order by the initiation of
tightening measures. The preparations for exit will allow us to move
with confidence when the time is right. They do not push us toward the
door. Indeed, the relatively modest pace of recovery, the continued high
rate of unemployment, subdued inflation trends, and well-anchored
inflation expectations together suggest that the need for highly
accommodative monetary policies will not diminish soon. Of course, we
should and will be attentive to new information suggesting otherwise.

As to the precise mix and sequencing of tools when the time to
tighten does come, the FOMC should continue to analyze conditions and
keep the public apprised of our thinking. But it seems to me neither
necessary nor advisable to decide upon a single game plan that will be
announced in advance and rigidly implemented after a decision is made to
raise rates. Apart from the key element of raising interest rates on
reserves, the optimal strategy will likely depend on the specific money
market and lending conditions that prevail at the time. For instance,
some circumstances might dictate the advisability of a quite rapid
sequence of reserve draining and interest rate raising steps, whereas
other conditions might argue for a more measured and incremental
approach.

Like many others–on and off the FOMC–I have certain
predispositions in considering the question of an exit strategy. For
example, I would be very cautious about any exit strategy that includes
early asset sales. While we ultimately want to move our balance sheet
back to a more traditional structure, the effects of such sales are very
uncertain, particularly in a period before a sustainable recovery is
well established. But, as with all monetary policy decisions, we should
ultimately tailor the particulars of our response to the circumstances
as we find them. If anything, the unprecedented nature of this exercise
means that we should be unusually attuned to economic and financial
conditions during, as well as before, our exit, and we should be
prepared to make prudent adjustments as necessary.

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