“When we get to the point where we feel like we need to reduce bank reserves, we will have a number of options to choose from,” he said to reporters.
“The natural place to start is asset sales,” he said.  “It is the one, to my mind, that we are the most sure that it would bring about a reduction in our monetary liabilities.”

From the Q&A session, as reported by Bloomberg News

We should keep [the Treasury and GSE asset purchase programs] a little bit open... [The Fed should] stay open to possibly purchasing more or possibly selling off assets in 2010.

What I’ve come to appreciate far better now after having had discussions, is that we have interest on reserves we can pay in the U.S.  That’s a relatively new tool.  Our initial experience in fall 2008 was not exactly perfect.  I think interest rates on excess reserves is one way to inject additional restraint on policy. 

You can do that even with a very large balance sheet.  We’d be learning about the effect of this tool.   We can do reverse repurchases.  We can sell assets. We can always do that. 

I’m confident that we can shift to a more restrictive policy when the time is approaching.  Presumably that’s an extended period beyond where we are now.

From comments to the press, as reported by Bloomberg News

Uncertainty over the outlook for inflation “is as high as it has ever been since 1980”, James Bullard, the president of the Federal Reserve Bank of St Louis, has told the Financial Times.

...

The St Louis Fed president said he would not favour tightening policy before recovery was well-established. “You are going to need to have jobs growth and you are going to need to have unemployment declining.”

But once the recovery looked solid and there were consistent good monthly job gains, the Fed could “remove some of the accommodation”.

Mr Bullard said tightening “does not have to involve as its first step moving the federal funds rate off zero”.

Instead, he favoured at that point selling back assets bought by the Fed in the course of its unconventional easing.

Most Fed officials fear that asset sales would rock the markets and push up long-term interest rates, including mortgage rates. However, Mr Bullard said: “It seems perfectly reasonable to me.” He argued that, with proper planning, asset sales did not need to be disruptive.

Living with a bloated balance sheet for too long would risk fuelling inflation, he warned. “I am concerned that if, over a longer term, you just leave this many reserves in the system, under any ­normal theory . . . that is raw material for the money supply.”

Uncertainty about the course of the economy is a lot lower than it was just a few short months ago. But we cannot lose sight that this uncertainty remains quite high; we are still in largely uncharted waters when it comes to fully understanding how our economy will recover from the severe recession and financial disruptions of the past several years and how that recovery and inflation will be affected by the extraordinary actions we took. We need to base policy on our best estimate of the evolution of inflation and output relative to our objectives, but we also need to be ready to adjust our plans if events don't turn out as predicted in either direction. We have the tools to exit our unusual policies when the time comes. And we must act well before demand pressures or inflation expectations threaten price stability.

In the event that the ability to pay interest on excess reserves for any reason proved insufficient or the excess reserves themselves had unanticipated side effects that the Fed wished to mitigate, we are developing a number of tools that can be used to drain reserves. Two such tools are large reverse repos with dealers and other investors and term deposit facilities for banks.

So, in the near term, resource slack is likely to depress core inflation measures, but over the medium term, stable inflation expectations will play a larger role. Nevertheless, some people still believe inflation is a serious risk based on the expanding U.S. fiscal deficit and the unprecedented actions taken by the Federal Reserve. These critics point to the large size of the Federal Reserve’s balance sheet, and they question the FOMC’s willingness to raise rates when the time comes to do so. They also cite concerns that the Federal Reserve will succumb to political pressure, and monetize the federal debt.

I have to tell you that I do not share these views. As the minutes of the recent FOMC meetings reveal, a variety of tools are being developed to ensure "that policy accommodation can ultimately be withdrawn smoothly and at the appropriate time." Without going into all of the details, I believe that the Federal Reserve has the tools necessary to manage the balance sheet, to make any needed changes in short-term interest rates, and to ensure that our purchase of Treasury securities is consistent with our dual mandate of price stability and maximum sustainable economic growth. When the time comes to start removing our policy accommodation, I am confident that we have the tools and the will to get the job done.

The opportunity for banks to earn interest on a highly liquid risk-free deposit at the Federal Reserve should put a reasonably firm floor under short-term rates, including the federal funds rate. To date, that floor has been somewhat soft, perhaps because not all participants in the federal funds market can hold deposits at the Federal Reserve, and because banks have been reluctant to allocate the needed capital to arbitrage a few basis points. But I am confident that when we begin to raise our deposit rate, it will put upward pressure on the rates on competing assets, increasing actual and expected short-term interest rates with the usual types of effects on other interest rates and asset prices.

Still, draining reserves at some point also will be an aspect of exiting. The large volume of reserves is contributing to the loose relationship of our deposit rate and market rates. In addition, although to date the high volume of reserves evidently has not increased bank lending or reduced spreads of rates on bank loans or other assets relative to, say, Treasury rates, it could begin to do so if banks start to perceive the risk-adjusted returns on loans as superior to our deposit rate. An increase in lending and narrowing of spreads on bank loans is a necessary and desirable aspect of the return to better-functioning markets and intermediation to promote economic growth. But spreads eventually could become narrower than what would be consistent with underlying risk, and lending could grow more quickly than appropriate for price stability if very high levels of reserves remain in place. We are developing new techniques for draining reserves, including reverse repurchase agreements against mortgage-backed securities and time deposits for banks at the Federal Reserve. And, of course, we retain the option to sell securities from our portfolio on an outright basis. The range of tools will permit us to drain large volumes of reserves if necessary to achieve the policy stance that fosters our macroeconomic objectives.

The concern expressed in some quarters over the growth last year of base elements of the money supply—namely, excess bank reserves and the Fed's balance sheet—strikes me as exaggerated. When the time comes, I am confident the Fed has the tools to reverse the assumed monetary stimulus and exit the policies put in place in reaction to the financial crisis and the recession.

Many of the Fed’s special credit facilities have been winding down at a rapid clip as financial markets have begun to function in a more normal manner. And my colleagues have come to accept the arguments I made regarding the necessity for the Fed to maintain its independence from the Treasury by not increasing its purchases of long-term Treasury securities. As to the Federal Reserve reducing its balance sheet so as not to monetize the excess reserves waiting to be converted to bank loans, I have been very clear: Given the lag between the time monetary policy is initiated and when it impacts the economy, that wind-down process needs to begin as soon as there are convincing signs that economic growth is gaining traction and that the lending capacity of the banking system is capable of expansion.

I am not alone on this front. I have faith my colleagues on the Federal Open Market Committee will stand and deliver in a timely way. And I expect that when it comes time to tighten monetary policy, my colleagues and I will move with an alacrity that, if needed, will be equal in speed and intensity to that with which we pursued monetary accommodation.

I would hazard the view that prudent risk management suggests that policy will likely need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities.

“We have spent 20 years refining ideas about interest rate rules and optimal monetary policy,” Bullard said. “We should now consider quantitative rules because we are at the zero bound, and may remain there for some time depending on how the economy performs.”

Bullard noted that while the FOMC had announced its intention to buy up to $1.75 trillion in asset-backed securities by the first quarter of 2010, “there has been little indication of how or whether these amounts might be adjusted given incoming information on economic performance.”

- from FRBSL press release

[T]he presence of a large volume of reserves on bank balance sheets--even when remunerated--could have undesired effects on the portfolio decisions of banks. So we continue to develop tools that enable the Federal Open Market Committee (FOMC) to drain or neutralize large volumes of reserves were the Committee to decide that doing so would support its objectives.⁵

As we become more confident that we are at the bottom of the recession and are moving into recovery, we must become more resolute in systematically reducing our balance sheet and raising interest rates to levels we might all agree are more in line with the economy’s long-run growth path.