Once the Fed decides to pare its balance sheet, it would need to sell securities at a “gradual and predictable” pace to “mitigate the uncertainty” from selling longer-term assets. “I would expect such sales when they came to put some pressure on financial markets,” she said.

“I would not expect to see a significant financial-market reaction to the conclusion” of the $600 billion in purchases, Yellen said.

“My personal predilection would be to get out of the MBS market as soon as possible,” Lacker said to reporters. “I think the housing finance market can easily withstand a substantial liquidation of our MBS holdings.”

Signs that inflation expectations are beginning to rise or that growth rates are accelerating significantly would suggest that it is time to begin taking our foot off the accelerator and start heading for the exit ramp. I would add that we should not be too sanguine in believing that such a time is a long way off or that the process will only be gradual. A stronger rebound in the economy or inflation than some now expect could require policy actions to be taken sooner and more aggressively than many observers seem to be anticipating. Allowing monetary policy to fall behind the curve can only result in greater inflation and more economic instability in the future.

The process of normalizing policy, even once it begins, will still leave unprecedented policy accommodation on the table... The FOMC may not be willing or able to wait until all global uncertainties are resolved to begin normalizing policy.

While, the goal in the long run is to achieve fiscal sustainability, "the first thing we should be doing is trying to get the slack out of the economy ... we need to be careful not to go the austerity route too quickly," Rosengren said.

The second element of the plan would be to announce that at each subsequent meeting the FOMC will, as usual, evaluate incoming data to determine if the interest rate on reserves and the funds rate should rise or not. Monetary policy should be conditional on the state of the economy and the outlook. If the funds rate and interest on excess reserves do not change, the balance sheet would continue to shrink slowly due to run-off and the continuous sales. On the other hand, if the FOMC decides to raise rates by 25 basis points, it would automatically trigger additional asset sales of a specified amount during the intermeeting period. This approach makes the pace of asset sales conditional on the state of the economy, just as the Fed’s interest rate decisions are. If it were necessary to raise the interest rate target more, say, by 50 basis points, because the economy was improving faster and inflation expectations were rising, then the pace of conditional sales would also be doubled during the intermeeting period.

I want to highlight the analogous character in practical effect of traditional monetary policy using interest rates and the less familiar asset-purchase tools we have employed since the federal funds rate hit its lower bound. Though some have argued otherwise, I believe the FOMC hasoperated for at least a decade with a consistent and fairly well understood rules-based framework. It is within this framework that I think about the desirability of both LSAP3 and the inevitable exit to a less accommodative policy stance.

...

Even though I personally am not expecting an immediate need to implement an exit, I think it's fully appropriate to revisit the implementation assumptions and tools readiness. As I contemplate an exit, two basic and obvious questions come to mind—when will it be appropriate to undertake an exit, and how to implement the exit.

...Since I think passive unwinding is probably not feasible, we will have to decide when to actively implement an exit strategy. And though the answer to when to do this is clear in concept, it is not straightforward in practice. Lags in the effects of monetary policy mean that action generally needs to be taken in advance of definitive changes in the path of economic activity and prices. That is why the policy framework I am describing emphasizes a forward-looking rule-like construct to which the FOMC would simply react.

Monetary policy works with a lag, and therefore we can't wait until we get to full employment and, you know, the target inflation rate before we start to tighten. We have to think in advance, which means we have to use our models and our other forms of analysis and market indicators and so on to try to project where the economy is heading over the next six to 12 months.

Once we see the economy is in a self-sustaining recovery and employment is beginning to improve and labor markets are improving, and meanwhile that inflation is stable at approaching roughly 2 percent or so, which I think is where you want to be in the long term on inflation. At that point, we'll need to begin withdrawing.

It's the same problem -- I just want to emphasize this -- it's not at all different from the problem that central banks always face, which is when to take away the punch bowl. And the only way you can do that is by making projections of the economy and -- and moving sufficiently in advance that you don't stay too easy too long. And we're quite aware of this issue and quite committed to price stability and we will continue to analyze our models and our forecasts and -- and move well in advance of the time that -- well in advance of the time that the economy is, you know, completely back to full employment.

From the Q&A session

Last November, after considerable deliberation, the FOMC decided to purchase an additional $600 billion of longer-term Treasury securities. This asset purchase program has been commonly referred to as QE2. Based on my reading of the economic outlook and challenges that the economy faces, I have expressed some doubts that the benefits outweigh the costs of this policy. However, I supported continuation of the policy in January because it is generally a good practice for a central bank to do what it says it is going to do unless circumstances significantly change. To do otherwise would undermine the institution’s credibility.

When the asset purchase program was adopted, the Committee also said that it would review its planned purchase program on a regular basis, and I take that promise to review seriously. Policy, after all, must also be dependent on the evolution of the economy so when the outlook for the economy changes in an appreciable way, so should policy.

Should economic prospects continue to strengthen, I would not rule out changing the policy stance to bring QE2 to an early close. Thus, I will continue to look at the data and consider revising my forecast and preferred policy path as we gain more information on economic developments in the coming months. If the growth rates of employment and output begin to accelerate or if inflation or inflation expectations begin to rise, then it may be time to begin taking our foot off the accelerator.

...

 The question is not can we do it, but will we do it at the right time and at the right pace. Since monetary policy operates with a lag, the Fed will need to begin removing policy accommodation before unemployment has returned to acceptable levels. Will we have the fortitude to exit as aggressively as needed to prevent a spike in inflation and its undesirable consequences down the road?

Say we wanted to raise the short-term interest rate to 1 percent. Then if we paid 1 percent on excess reserves to banks, they would not be willing to lend money to the money market at less than 1 percent, and that would essentially achieve our objective right there. But there are other tools we have to drain reserves, including time deposits, reverse repos, asset sales and perhaps others.

From the Q&A session

Of course, those who worry about the inflationary consequences of our balance sheet may be looking to the future. As the economy improves, banks may use their reserves to rapidly expand business lending – increasing economic activity and putting upward pressure on inflation.  But as Chairman Bernanke has emphasized, the Federal Reserve has at its disposal a variety of tools that will allow it to remove reserves from the banking system once economic conditions get closer to normal. Thus the fear that our large balance sheet and the large stock of reserves in the banking system will cause inflation – either now or down the road – seems misplaced to me.

If the economy begins to grow more quickly and the sustainability of this recovery continues to gain traction, then the purchase program will need to be reconsidered along with other aspects of our very accommodative policy stance. We are a year and a half into a recovery, although a modest one. The aggressiveness of our accommodative policy may soon backfire on us if we don’t begin to gradually reverse course. On the other hand, if serious risks of deflation or deflationary expectations emerge, then we would need to take that into account as we adjust our policy stance.

[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.

[I]f growth picks up next year, as I and many other FOMC participants expect, the precautionary demand for liquidity by households, firms and banks will diminish. At some point we will need to respond by reducing the provision of liquidity to the banking system to prevent inflation from accelerating, as it often can when a recovery picks up steam. Further balance sheet expansion now could require more rapid balance sheet reduction later on, complicating the withdrawal of monetary stimulus when it becomes necessary to maintain price stability. It is appropriate, therefore, that the FOMC has committed to "regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed."

Even with the best of intentions, if we don’t act aggressively and promptly, we may find ourselves behind the curve and at risk for substantial inflation. I think we need to bear in mind this future potential complication when considering further expansion of the Fed’s balance sheet.