The Federal Reserve must, of course, be very careful to avoid any perception that it stands ready to monetize exploding fiscal deficits, as this would undermine confidence in our independence and raise serious doubts about our commitment to long-term price stability. These concerns certainly do not preclude some Treasuries purchases, however, as we seek to strengthen the economy in this time of crisis. With short-term Treasury rates near zero, an argument can be made that buying longer-term Treasuries would be especially effective in this regard.

Parenthetically, I would note that such purchases are not at all unusual. We routinely buy Treasury issues with a wide range of maturities in order to maintain a well-balanced portfolio. So, we are talking only about a possible change in emphasis here, not a sharp departure from past practice. That said, in my opinion, we certainly shouldn't try to peg long-term rates. Past efforts to do so soon have led to costly credit-market distortions and inevitably ended in tears. In my view, we must be very careful not to provide for an unsustainable and potentially disruptive distortion in the benchmark market for Treasuries through any extraordinary efforts above and beyond our normal balancing operations.

Similarly, we must be very cautious about the dimensions of our program to intervene directly in the market for asset-backed securities, making sure that our actions are the absolute minimum needed, and no more. Most important of all, we must continue to make clear that we will unwind our interventions in the market and shrink our balance sheet back to normal proportions once our task is accomplished, for this is, indeed, our unanimous and unflinching intention.

[A]t some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply and begin to raise the federal funds rate. To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink. 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 other terms 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 phased out once credit market conditions substantially normalize. However, the principal factor determining the timing and pace of that process will be the Federal Reserve's assessment of the condition of credit markets and the prospects for the economy.

Very important to us that we, again, design these programs that have the least risk to the taxpayer and the most benefit for getting our economy back on track. That's the overriding principle that guides everything we do.

I'll give you an example of how we try to navigate through this. In this lending facility that you described, this is designed in a way so that we have independent pricing with haircuts for margin that are designed to be conservative in normal times so that the overall economics of this work in a way that as conditions normalize, market's demand for this will fade away. It won't be economic to use these facilities. Demand will fade. That's the basic structure.

From the Q&A session

As I have indicated, some of our new lending facilities were created to replace impaired or poorly functioning private credit markets. We must consider the possibility that our presence in these credit markets will deter private-sector participants from returning to and restoring these markets. To prevent our policies from having these perverse effects, we should consider a gradual increase in the cost of borrowing from these facilities to discourage their use and encourage other participants to return to these markets. This should be an important element of our exit strategy.

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.

Moreover, other tools are available or can be developed to improve control of the federal funds rate during the exit stage.  For example, the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control.  Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system.

(I)t will not be sufficient simply to roll back the current lending programs when the economy begins recovering. The precedents that have been set during this episode will influence how market participants expect policymakers to react during the next episode of financial market turmoil. Establishing a coherent and stable financial regulatory regime will require rolling back expectations about how the policymakers will respond to the next financial market disturbance or the next recession. Doing so will be difficult. But rolling back those expectations will be impossible if moral hazard concerns are always set aside in the exigencies of a crisis.⁵

I start from the premise that central banks should not allocate credit or be market makers on a permanent basis. That should be left to the market--or if externalities or other market failures are important, to other governmental programs. The Federal Reserve should return to adjusting reserves mainly through purchases and sales of the safest and most liquid assets as soon as that would be consistent with stable, well-functioning markets. In fact, several of the Federal Reserve's new programs are designed to be self-liquidating as markets improve. Minimum bid rates and collateral requirements have been set to be effective when markets are disrupted but to make participation uneconomic when markets are functioning well. Under current law, our facilities for investment banks that don't involve securities eligible for open market operations (OMO-eligible paper) will necessarily be wound down when circumstances are no longer "unusual and exigent"; I'll come back to questions about these facilities in a minute.

However, the Federal Reserve's auction facilities have been an important innovation that we should not lose. They have been successful at reducing the stigma that can impede borrowing at the discount window in a crisis environment and might be very useful in dealing with future episodes of illiquidity in money markets. The new auction facilities required planning and changes in existing systems, and we should consider retaining the new facilities for the purposes of bank discount window borrowing and securities lending against OMO-eligible paper, either on a standby basis or operating at a very low level when markets are functioning well in order to keep the new facilities in good working order. The latter might require that we allow the auction to set the price without a constraining minimum, but a small auction should not distort the allocation decisions of private participants.