Taken together, the economic data generally point to an economy that is moving in the right direction and has consistently sustained growth over the past five years. This is not to say the economy is issue-free… Unfortunately, although we might wish it so, monetary policy is not the proper tool to address all of these issues. The aggressive monetary actions over the past few years were intended to support economic activity, help labor markets heal and move inflation toward the Fed’s target. I view the considerable progress in labor markets and the relatively steady inflation rate as encouraging. However, keeping interest rates near zero to achieve still further progress toward labor market improvement and higher inflation is risky in my view. In a protracted period of exceptionally low rates, investors seeking out higher returns are willing to take on more risk or seek out more creative financing approaches. When the economy is expanding and rates remain low, adverse events may appear less likely or far into the future, potentially resulting in the mispricing of risk and financial assets. Waiting too long to adjust rates, as we’ve seen in the past, can leave policymakers with few and possibly poor options. … The FOMC has been talking about its exit strategy since 2011. And since March of this year, the Committee has been emphasizing that a decision to raise interest rates would be data dependent. In other words, economic data that confirms further gains in the economy’s performance will drive the timing of the Committee’s actions. So, why hasn’t the FOMC yet raised rates? There are of course different views on the economic data we receive and analyze that lead to legitimate, differing views about what is best for the economy… The continued improvement in the labor market, combined with low and stable inflation, convince me that modestly higher short-term interest rates are appropriate. Current guideposts, or “policy rules,” often used to inform monetary policy decisions also have been signaling that interest rates should be higher. I recognize that a rate increase, however, would be the first one in nearly a decade. So I am not suggesting rates should be normalized quickly or that policy should be tight. Although the economy has improved, economic fundamentals could well mean an accommodative stance of policy is appropriate for some time. I would like to avoid the cost of waiting for more evidence and further postponing liftoff, drawing on a valuable lesson from monetary policy decisions in 2003.

In sum, arbitrage activities by banks, complemented as needed by ON RRP operations, should cause a higher IOER rate to lead to higher levels of market rates. However, if the pressure on market rates from the Feds administered rates turns out to be insufficient, the Committee has a range of other tools including term deposits, term RRPs, and asset salesthat could be used to help tighten the stance of policy. Given the array of tools at our disposal, I am confident that the FOMC can adjust and control short-term interest rates as needed to foster its objectives of maximum employment and price stability. Given the range of available tools, I am confident in our ability to raise short-term interest rates from the zero lower bound when the time to do so arrives. Nevertheless, the FOMC is prepared to adjust the details of its approach to policy normalization in light of economic and financial developments and the Desk stands ready to innovate in order to efficiently and effectively implement policy consistent with the Committees directive.

The Committees normalization principles and plans do not detail the manner in which IOER as a primary tool would be combined with supplementary tools such as ON RRPs to move the fed funds rate into the target range. However, as reflected in the minutes to the July FOMC meeting, most Committee participants anticipate that, at least initially, the IOER rate could be set at the top of the target range for the funds rate, and the ON RRP rate could be set at the bottom of that range. This is also consistent with the views of many market participants as reflected in surveys conducted by the Desk. [A]s the Chair noted during her September press conference, the Committee expects that the effective fed funds rate may vary within the target range and could even move outside of it on occasion. For example, the effective rate could move outside the target for a day or two around key financial reporting dates, such as quarter-ends, when some banks marginal balance sheet costs are particularly high. However, such transitory movements should have no material effect on financial conditions or the broader economy. What matters for policy transmission is the predictability that on most days money market rates will be close to the target range set by the FOMC.

It's not obvious to me a larger balance sheet should change any of our exit principles... I still think we should, as our [2011] exit principles say, be exiting from mortgage backed securities as soon as we can, to reduce the extent to which we are allocating credit and distorting credit markets... I don't see any tremendous benefit to not doing what we said we would do.

Jeffrey Lacker says projections that the central bank will raise the benchmark interest rate next year are "reasonable... Getting the timing right is going to be tricky."

We need to get much, much closer to two percent before we even contemplate liftoff, Evans told reporters after a presentation at the Istanbul School of Central Banking today. Whether that's late 2015 or early 2015 or 2016, it'll depend on the economy.

I've given you the broad strokes of a pretty optimistic outlook...

As confirming evidence, I'll be paying attention to consumer spending and consumer confidence. Data on both have been, on balance, encouraging. I'll be monitoring industrial activity closely. While the manufacturing production numbers stepped down in April following very strong gains in February and March, the April report from purchasing managers on production and orders was quite positive. And I'll be looking for sustained employment gains...

At any given juncture, absolute certainty of the economy's direction is not achievable. As I've suggested, I feel the need to see confirming evidence in the data validating the view that above-trend growth is occurring and is sustainable, and that the FOMC is closing in on its policy objectives. One quarter's data isn't enough. I expect it will take a number of months for me to arrive at conviction on that account.

When the first move to tighten policy is taken, I would expect it to begin a cycle of gradually rising rates. This will be a significant, even historic, transition that must be executed skillfully, with tools sufficient to the task, and with clear communication that fosters orderly market adjustment, to the extent possible. The discussion of so-called policy normalization documented in the latest minutes of the FOMC was just a first step, in my opinion.

It bears repeating that a discussion of policy normalization does not necessarily imply that a shift in policy is imminent. For the reasons I have discussed, I, as one policymaker, am not in a rush to get to liftoff. I continue to be comfortable with a projection of the second half of next year (2015) as likely timing.

At this point, it would take a substantial shift in the economic outlook to derail the tapering process.

I say this a lot, because its an important message to get across: The taper does not reflect a tightening of monetary policy. Were not putting out the fire, were just gradually adding less and less fuel. Its just one small step towards policy normalization, when the economy has sufficient heat on its own. A real tightening of policywhich would mean raising the fed funds rateis still a good way off.

So we all expect to our balance sheet to gradually decline over time after we regard it is appropriate to begin to tighten policy. We have not decided and will probably wait until we're in the process of normalizing policy to decide just what our long-run balance sheet will be. But clearly it will be substantially lower than it is now, and it will take a period of a number of years. This is -- this could happen simply by ending our reinvestment policy at some point. If we did that and nothing more, it would probably take somewhere in the neighborhood of five to eight years to get it back to pre-crisis levels.

 BRADY: Thank you, Mr. Chairman.  If the economy were to accelerate, the Fed would have to start unwinding QE3. So what is the Fed's exit strategy, the steps you'll undertake? And when do you anticipate, again, executing this?

BERNANKE: Mr. Chairman, so first -- the first thing, of course, would be to wind down eventually the quantitative easing program, the asset purchases. As I've said, the program relates the flow of asset purchases to the economic outlook. As the economic outlook and particularly the outlook for the labor market improves in a real and sustainable way, the committee will gradually reduce the -- the flow of purchases.

I want to be very clear that a step to reduce the flow of purchases would not be an automatic mechanistic process of -- of ending the program. Rather, any change in the flow of purchases would depend on the incoming data and our assessment of how the labor market and inflation are evolving.

   So at some point, of course, we will end the asset purchase program. Subsequent to that we will follow the guidance that we've provided about interest rates. Our principal tool for raising interest rates will be the interest rate on excess (ph) reserves that we pay, which will induce higher money market rates and a higher federal funds rate. And we will complement that with other tools, including tools that we have for draining reserves. 

    We may or may not sell assets. At this point it does not appear that it is necessary for us to sell any assets -- or particularly not any mortgage-backed securities -- in order to exit in a way that doesn't endanger price stability. 

    So there are a number of steps. We are currently discussing further our exit strategy, and we hope to provide more information going forward. But we certainly are confident that we can exit over time in a way that will be consistent with our policy objectives. 

    BRADY: You anticipate allowing maturing securities to roll off the balance sheet before you begin selling securities themselves? 

    BERNANKE: As I said, we -- we could normalize policy by simply letting securities roll off, and I think there's some advantages to doing that. For one it wouldn't disrupt markets so much. It would avoid as much irregularity in our fiscal payments to the Treasury. But we will see, ultimately, in the very long run, I think there's a desire to get back to a predominantly Treasury security portfolio. 

    But, again, in the exit process, allowing assets to roll off would be sufficient to bring us to a more normal balance sheet within a reasonable period. 

The other important point to make here is when we're doing purchases, if we continue to do purchases, we're adding stimulus. And people act like if we dial the rate of purchases down somehow we're tightening monetary policy. What we're actually doing is adding less stimulus.

Because the outlook is uncertain, I cannot be sure which way—up or down—the next change will be. But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook. At that time, in my view, it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases. Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment.

....

There is a risk is that market participants could overreact to any move in the process of normalization. Indeed, there is some risk that market participants could overreact even before normalization begins, when the pace of purchases is adjusted but the level of accommodation is still increasing month by month.11 Not only could such responses threaten financial stability, but also they might make it harder to calibrate monetary policy appropriately to the economic situation. We will need to think long and hard about how best to develop policy in a way that enables us to respond flexibly to a changing economic outlook, but in a way that is not disruptive to the economy.

The so-called quantitative easing that has swollen the Fed balance sheet to $3.32 trillion may lead to “complications” as the central bank begins to exit the policy, George said. Risks include a jump in longer-term inflation expectations and a “painful adjustment” for investors when the benchmark interest rate is eventually raised, she said.

“Continuing this current policy outside of the crisis, outside of a recession, poses risks to us in the long term,” George said.

In March 2011, I shared some principles I thought should guide the Fed's eventual exit from this period of extraordinary monetary policy and its attempts to normalize policy. I said at the time that an effective exit strategy had to begin by deciding on our destination — what monetary policy operating framework we will use after exit — and then articulating a systematic approach to getting there. I was gratified that in June of the same year, the Federal Open Market Committee (FOMC) adopted a similar set of exit principles.

…

In addition to stopping asset purchases, the Fed should take two other steps as precursors to exit. First, we should seek to normalize the spread between the discount, or primary credit, rate, the rate at which banks borrow from the central bank, and the target federal funds rate... More than three years later, the crisis has passed and the other temporary lending programs the Fed initiated during the height of the crisis have disappeared. Thus, it may be a reasonable time to restore the spread to a more normal level.

Second, another step that might be taken before exit begins is to rethink our reinvestment strategy. There are no longer any short-term Treasuries in the Fed's portfolio. Rather than reinvesting maturing assets and prepaid assets into longer-term assets, it might be prudent to begin reinvesting in shorter-term assets. That would provide more flexibility in managing our balance sheet as we move forward.

If we do not stop purchases soon, one part of the exit strategy that might need to be reconsidered is asset sales… Determining the optimal pace of normalization from a very large and long-duration balance sheet is a complicated task that will depend on the speed with which interest rates rise and the size of the balance sheet when normalization commences. One factor to consider is the fiscal implications... Over time as the economy improves, interest rates will rise. Since the Fed's portfolio holds predominantly longer-term securities, interest received will not rise appreciably, but the interest paid on reserves will have to go up. Roughly speaking, if reserves total $2 trillion, remittances to the U.S. Treasury will fall by $20 billion for each 100-basis-point rise in the IOR…

In addition, should the Fed choose to sell long-term assets in a rising interest rate environment, it could experience capital losses. This would further reduce remittances to the Treasury. The more aggressively the Fed sells off its assets, the higher the losses and the more likely remittances to the Treasury could turn negative for a number of years. Although negative remittances would not impair the Fed's ability to implement monetary policy, they may impose significant political risk for the institution.

If asset purchases continue at current levels, reserve balances could grow to $2.25 trillion or more. That may require the Fed to sell assets at a somewhat faster pace than contemplated in the principles adopted in 2011.