“Balance sheet policy, like all monetary policy, should be conducted in a state-contingent way,” Bullard added. (In other words, policy should be adjusted based on the state of the economy.)

The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases. I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation. And I expect I will be at the forefront of the effort to trim back our Treasury holdings and tighten policy at the earliest sign that inflationary pressures are moving beyond the commodity markets and into the general price stream. I am a veteran of the Carter administration and know how easily prices can spin out of control and how cruelly markets can exact their revenge. I would not want to relive that experience.

The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we have reached our limit. I would be wary of further expanding our balance sheet

[I]n a 2006 speech about the historic use of monetary aggregates in setting Federal Reserve policy, Chairman Bernanke pointed out that, "in practice, the difficulty has been that, in the United States, deregulation, financial innovation, and other factors have led to recurrent instability in the relationships between various monetary aggregates and other nominal variables." Still, my colleagues and I will be monitoring a wide range of financial and economic developments very closely -- including the growth of the money supply, inflation, and many other financial and nonfinancial variables -- and, based on a full assessment of those developments, the FOMC will withdraw monetary accommodation at the appropriate time. My view is that the elevated reserve balances would be inflationary only if they prevented the FOMC from effectively removing monetary accommodation by raising interest rates when the time comes to remove such accommodation, and I am convinced that that will not be the case.

Earlier this week, I prepared for this lecture by speaking to some of your undergraduate students by phone. One of the most memorable of them described the Fed's balance sheet as being "really pimped out!" I would not have chosen those words, but, yes, our balance sheet is presently gussied up. We aim to get back to the basics of holding mostly plain vanilla Treasuries—in size needed solely for conducting prudent monetary policy—on the asset side of our balance sheet. And we wish to have banks put their reserves to work, financing growth of the businesses of America, rather than piling those reserves up on the liability side of our balance sheet.

The Federal Reserve's purchases have had the effect of leaving the banking system highly liquid, with U.S. banks now holding more than $1.1 trillion of reserves with Federal Reserve Banks. A range of evidence suggests that these purchases and the associated creation of bank reserves have helped improve conditions in mortgage markets and other private credit markets and put downward pressure on longer-term private borrowing rates and spreads.

From a technical point of view, I do not see a problem {with the Fed upholding its price stability mandate}– we do have the tools to contract our balance sheet and remove monetary stimulus when we need to do so, as Chairman Bernanke explained in detail in last month’s Monetary Policy Report to Congress. The harder problem is choosing when and how rapidly to remove stimulus as the recovery begins. I am certainly aware of the danger of aborting a weak, uneven recovery if we tighten too soon. But there can be a strong temptation to hesitate when emerging from a recession, awaiting conclusive signs of robust growth. Keeping inflation well-contained may require action before a vigorous recovery has had time to establish itself.

Despite the recent dip in the size of the balance sheet, the size of the purchase programs underway makes it likely that balance-sheet growth will resume as assets acquired in conjunction with these programs overwhelm any further declines in the funds advanced via the shorter-term liquidity facilities. The size of the Federal Reserve’s balance sheet seems likely to grow to roughly $2.5 trillion, somewhat above the peak reached last December.

[A] significant portion of our balance sheet may not shrink on its own or at the appropriate rate. We need tools to reduce it actively so that monetary policy can be easily recalibrated. In this respect, we can be as creative on the way out as we were on the way in; or, put another way, we can be creative with our liabilities the way we have been creative with our assets.

In thinking about this balance sheet expansion, I would make three broad points. First, in my mind, the goal is not the expansion of the balance sheet per se, but the objectives that I laid out earlier. In this respect, the expansion of the balance sheet differs considerably from Japan’s experience with quantitative easing...  Although the Fed’s activities have led to a big jump in excess reserves, this increase is incidental—a byproduct rather than goal of the asset-oriented programs.

Second, as a consequence of this my point, the size of the balance sheet, is not a good metric for measuring the impact of the Fed’s facilities or the amount of stimulus that the Fed is providing via these programs...  It is not possible to mechanically map the size of the balance sheet back onto the impact on financial market conditions... The size of the balance sheet is also not a good standard because the use of the different facilities depends on the degree of impairment in market function...

Third, I am not worried at all that the Federal Reserve’s balance sheet expansion will generate an inflation problem... [T]he Federal Reserve now has the tools to allow the conduct of monetary policy to be separated from the size of the balance sheet and the amount of excess reserves in the banking system.

Mixing monetary and fiscal policy is fraught with risks. Many historical instances of monetary instability have been the result of central banks being prevailed upon to use their balance sheets for fiscal ends in ways that impeded their ability to keep inflation under control. That is why in recent decades, countries around the world have provided a measure of independence to their central banks, within frameworks that ensure accountability, in order to explicitly insulate them from short-run political exigencies that might diminish the credibility of their commitment to control inflation. The cornerstone of that framework in the United States dates back to 1951, when the Treasury-Fed Accord formally gave the Federal Reserve independent control of its balance sheet.⁸

...While at the present time, credit programs do not conflict with our monetary policy strategy, there could well come a time at which monetary stimulus needs to be withdrawn to prevent a resurgence of inflation, even though credit markets are not deemed fully healed. At that time, containing inflation may require closing down credit programs, or finding an alternative, non-monetary financing arrangement for them. Price stability, after all, is the vital first ingredient in financial market stability.

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs.  To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities.  Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize.  In addition, some programs--those authorized under the Federal Reserve's so-called 13(3) authority, which requires a finding that conditions in financial markets are "unusual and exigent"--will by law have to be eliminated once credit market conditions substantially normalize...

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline..  A significant shrinking of the balance sheet can be accomplished relatively quickly. .. as the various programs and facilities are scaled back or shut down.  As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.

Although a large portion of Federal Reserve assets are short-term in nature, we do hold or expect to hold significant quantities of longer-term assets, such as the mortgage-backed securities that we will buy over the next two quarters.  Although longer-term securities can also be sold, of course, we would not anticipate disposing of more than a small portion of these assets in the near term, which will slow the rate at which our balance sheet can shrink.  We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.

(W)hile inflation is receding for the moment, I must remind you that monetary policy is extremely accommodative, and if it remains so too long, as history suggests it may, inflation pressures could re-emerge as the economy recovers.
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Inflation will remain moderate over 2009 and much of 2010.  Lower energy and commodity prices along with moderate improvement in demand for goods and services will keep price pressures temporarily contained.  How prices behave beyond the immediate horizon depends most critically on how the Federal Reserve conducts policy and manages its expanding balance sheet in a strengthening economy.  This is no doubt the central bank's most difficult long-run challenge.

The Federal Reserve is not only providing liquidity to the financial industry, it is also taking on the financial industry's role as intermediary to business firms.  This is a dramatic expansion of the central bank's role in the economy.  It is reflected most vividly in the combined balance sheet of the 12 Reserve Banks, which has increased from $900 billion in mostly Treasury securities in the fall of 2007 to $2.3 trillion in other assets today, and this will increase still further in the months ahead.

The Federal Reserve must now manage its balance sheet in a manner that not only places liquidity into the economy but also in a manner that does not undermine the long-term functioning of markets.  It must design an exit strategy that at the appropriate time both removes excess liquidity from the economy and allows it to withdraw as a significant intermediary.  Failure to have such a strategy risks undermining an efficient financial market system.

The Fed's current "balance sheet approach" to monetary policy creates an entirely new set of policy issues and challenges... In effect, the Fed must judge where to intervene, deciding where market dysfunction is greatest and where adverse consequences for the overall economy are particularly severe. Furthermore, many of the interventions are novel, so no straightforward methods are available to quantify their effectiveness. There are also no clear guidelines for the Fed to gauge the appropriate size of its interventions and few precedents for the Fed to use in communicating its policy stance to the public beyond announcing new programs and describing their terms in detail. Although the purpose of most programs is to lower borrowing costs, the Fed must be careful to avoid the risks that could result from targeting some predetermined yield or spread. Finally, the Fed must ensure that it has an exit strategy to wind down the facilities in a timely and effective way when they are no longer needed.