Federal Reserve Chairman Ben S. Bernanke said the Fed will raise the interest rate on excess reserves as its primary tool for tightening monetary policy rather than selling assets from its balance sheet.

“The principal tool that we contemplate is the interest rate paid on excess reserves,” Bernanke said today in response to audience questions at a conference in Stone Mountain, Georgia. During a tightening, money market rates will probably stay close to the interest rate on excess reserves, he said.

“We have said in our existing exit principles we may sell assets in a steady way,” he said. Still, “asset sales are late in the process and not meant to be the principal tool of policy normalization.”

“I’m personally in favor of tapering back our mortgage- backed security purchases,” Fisher told reporters today at a conference in Abu Dhabi. “I think we’ve assisted the recovery of the housing market. We have a pretty robust housing situation right now. We don’t want to slip backwards."

As reported by Bloomberg News

Long-term yields rose sharply in 1994 and 2004 when economic recoveries got underway in earnest after sustained periods of unusually low short-term rates. Compared to those episodes, the risk of a spike in long-dated yields this time around may be somewhat lower for two reasons. First, this risk is receiving much attention. Big market moves are typically associated with surprises. For the market to reprice suddenly, I presume there would need to be some new information that led investors to significantly revise their view of the outlook or the Fed's reaction function.

Second, the Fed's expansion of its own balance sheet may be a stabilizing influence. For example, the rise in interest rates during the prior episodes was amplified by convexity-related hedging generated by the lengthening of expected mortgage duration. This should be a less powerful force this time around because the Fed holds a substantial portion of the agency MBS market.

[I]t is entirely possible that it might be appropriate at some point to adjust the pace of MBS purchases in response to developments in primary or secondary mortgage markets. Within the context of the Committee's judgment about the appropriate overall level of monetary accommodation, such an adjustment could result in an increase or decrease in the pace of total asset purchases, or it could lead to a change in the composition of purchases.

The FOMC’s current asset purchase program has some key differences from earlier policy initiatives… Under the current asset purchase program, the FOMC has announced only the monthly pace and composition of purchases and noted that purchases will continue until there is a substantial improvement in the outlook for the labor market in the context of price stability. The Committee has also indicated that it will take appropriate account of the likely efficacy and costs of its purchases when adjusting their size, pace, and composition… Instead, under this conditional, outcome-based approach, the Committee has enacted a policy that will adjust to incoming information about labor market conditions and the broader economy, as well as its ongoing assessment of the efficacy and costs of purchases. Retaining the flexibility to adjust purchases is an important feature of the program, given our relatively limited experience with the use of the balance sheet as a monetary policy tool and the uncertainty about the policy’s effects.

In terms of exiting from our balance sheet, we have put out -- a couple of years ago we put out a plan. We have a set of tools. I think we have belts, suspenders, two pairs of suspenders; we have different ways that we can do it. So I think we have the technical means to unwind it at the appropriate time.

US Federal Reserve officials fear a backlash from paying billions of dollars to commercial banks when the time comes to raise interest rates. The growth of the Fed’s balance sheet means it could pay $50bn-$75bn a year in interest on bank reserves at the same time as it makes losses and has to stop sending money to the Treasury.

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Mr Bullard said that neither interest paid to banks nor possible losses on exit made any difference to the substance of monetary policy.

“I think it’s more just a question of the optics, and how you’re going to play the optics,” he added, referring to the perception of losses by the central bank. “And since it shouldn’t matter in a monetary policy sense you might as well play the optics in a better way than the one we’ve got planned.”

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One possible answer to the Fed’s larger balance sheet is to sell assets earlier in the exit process. Mr Bullard said that the Fed could consider creating accounting reserves now for any losses it expects in the future.

Federal Reserve Bank of Philadelphia President Charles Plosser said he expects the unemployment rate to decline close to 7 percent by the end of this year, warranting a reduction in the Fed’s monthly bond purchases.

“If my forecast is right, then I think we should at least have begun backing off on our asset purchases,” Plosser told reporters yesterday after delivering a speech in Stanford, California. “As a practical manner, we will taper” bond buying before halting the quantitative easing program, he said.

As reported by Bloomberg News

“We should think about tapering or adjusting the program,” Bullard said yesterday in an interview in Washington. “If you get some good data for a couple of months, maybe you’d say, ‘Okay, we go back to $75 billion per month instead of $85 billion or something like that.’”

“You don’t want that cold turkey aspect to the program,” he said. “If we got some good signs through the spring or the summer, then I think we could throttle back just a little bit without saying you are going to end the program on any particular day.”

I dissented from these Committee actions and have expressed my concerns at length elsewhere. Briefly, as I’ve touched on today, I think that further monetary stimulus is unlikely to materially increase the pace of economic expansion, and that these actions will test the limits of our credibility. At some point, we will need to withdraw stimulus by raising interest rates and reducing the size of our balance sheet, and the larger our balance sheet, the more vulnerable we will be to seemingly minor miscalibrations in policy. Accordingly, I see an increased risk, given the course the Committee has set, that inflation pressures emerge and are not thwarted in a timely way.

In my view, the supply of bank reserves is already large enough to support the economic recovery, and the benefits of further asset purchases are unlikely to be sizeable. The effects on longer-term interest rates are uncertain and likely quite small, and the potential to boost job creation seems quite limited, given the fundamental impediments that appear to be restraining growth now. At the same time, it’s important to recognize the potential costs of additional asset purchases. A larger Fed balance sheet will increase the risks associated with the timely and appropriate withdrawing of monetary stimulus by raising interest rates and selling assets.

My assessment was that the costs associated with additional asset purchases outweighed the expected benefits, and thus, I dissented.

In the past, I have said we should hold the fed funds rate near zero at least as long as the unemployment rate is above 7 percent and as long as inflation is below 3 percent. I now think the 7 percent threshold is too conservative. Our latest actions put us on a better policy path than we had when I first proposed the 7/3 markers a year ago. At the same time, there still are few signs of substantial inflationary pressures. If we continue to have few concerns about inflation along the path to a stronger recovery there would be no reason to undo the positive effects of these policy actions prematurely just because the unemployment rate hits 6.9 percent — a level that is still notably above the rate we associate with maximum employment.

This logic is supported by a number of macro-model simulations I have seen, which indicate that we can keep the funds rate near zero until the unemployment rate hits at least 6-1/2 percent and still generate only minimal inflation risks. Even a 6 percent threshold doesn’t look threatening in many of these scenarios. But for now, I am ready to say that 6-1/2 percent looks like a better unemployment marker than the 7 percent rate I had called for earlier.

Given that the current inflation rate is quite low and is expected to stay low for several years, we have the flexibility to push for more improvement in labor markets than if inflation were not so subdued. My own personal assessment is that as long as inflation and inflation expectations are expected to remain well-behaved in the medium term, we should continue to forcefully pursue asset purchases at least until the national unemployment rate falls below 7.25 percent and then assess the situation.

I think of this number as a threshold, not as a trigger – and the distinction is important. I think of a trigger as a set of conditions that necessarily imply a change in policy. A threshold, unlike a trigger, does not necessarily precipitate a change in policy. Instead, I think of my proposed threshold as follows. Once the unemployment rate declines to this level, we would undertake a full assessment of labor market conditions and inflationary pressures to determine whether further asset purchases are consistent with the desired trajectory for reaching our inflation and unemployment mandates in the medium term. Thus, a threshold precipitates a discussion and a more thorough assessment of appropriate policy, versus a trigger which starts a change in policy.  As an example, suppose we reach one’s threshold unemployment rate but at that time the economy is slowing, and no further improvement in the unemployment rate is expected in the short to medium term. This hypothetical situation would not necessarily imply a change in policy stance, especially if inflation was projected to remain below target.

Let me say also that an unemployment rate of 7.25 sounds high, but achieving an unemployment rate of 7.25 percent would require real GDP growth of roughly 3 percent for a year. That would be growth that is a full percentage point faster than the economy’s so-called “potential” rate of growth, making this a challenge to achieve.

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Despite the challenge to communicating in simple terms the likely exit strategy, I will say that my own preference would be to continue asset purchases until we had at least reached an unemployment rate of 7.25 percent, given the low rates of inflation we have been experiencing and are likely to be experiencing over the medium term – however, I will say again that this is a threshold, not a trigger. Assuming that inflation and inflation expectations remain well-behaved, at that point the discussion should center on whether overall labor market conditions are consistent with “substantial improvement” – for example, whether the lower unemployment rate reflects job creation rather than reductions in the labor force as discouraged workers stop seeking jobs; whether we are seeing sustained, robust payroll employment growth; and whether we envision continued substantial improvement in labor markets for some quarters to come. Under those conditions, I would stop asset purchases.

It is clear that the larger the Fed’s portfolio becomes, the greater the risk and the potential costs when it comes time to exit. And based on my economic outlook, that time may come well before mid-2015. In my view, to keep the funds rate at zero that long would risk destabilizing inflation expectations and lead to an unwanted increase in inflation. In fact, some are interpreting the FOMC’s statement that we will keep accommodation in place for a considerable time after the recovery strengthens as an indication that the Fed is focused on trying to lower the unemployment rate and is willing to tolerate higher inflation to do so. This is another risk to the hard-won credibility the institution has built up over many years, which, if lost, will undermine economic stability. We know that monetary policy can control inflation, but its ability to manage the unemployment rate is far more dubious. Chasing an elusive goal for unemployment could well risk losing control over inflation. That was the lesson of the Great Inflation during the 1970s.

Finally, I also opposed September’s decision to purchase additional mortgage-backed securities. In general, central banks should refrain from allocating credit toward one sector or industry. Those types of credit-allocation decisions rightfully belong to the fiscal authorities, not the central bank. Engaging in such actions endangers our independence and the effectiveness of monetary policy.

There is in the marketplace a lingering fear that the Fed has already expanded its balance sheet to its stretching point and that an exit strategy, though articulated, remains theoretical and untested in practice. And there is a growing sense that we are unwittingly, or worse, deliberately, monetizing the wayward ways of Congress. I believe that were we to go down the path to further accommodation at this juncture, we would not simply be pushing on a string but would be viewed as an accomplice to the mischief that has become synonymous with Washington.