Eventually, I would like to see the Federal Reserve’s balance sheet shrink toward more normal levels. And I’d like the bulk of our holdings to be Treasury securities, as they were prior to the crisis. Selling off some of our assets could play a role in this shift, but my expectation is that the FOMC will reduce the size of our balance sheet only gradually over time.

In particular, {Chairman Bernanke} indicated that he does not currently anticipate that the Fed will sell any of its asset holdings until the economic recovery is more firmly established and policy tightening has gotten underway. Until that time, the portfolio would shrink only through asset redemptions.  Chairman Bernanke noted that the Fed's holdings of agency debt and MBS are being allowed to roll off the balance sheet, without reinvestment, as those securities mature or are prepaid, and that the FOMC may choose to redeem some of its holdings of Treasury securities in the future, as well.

With this approach, the FOMC would be shrinking its balance sheet in a gradual and passive manner. That, in my view, is a crucial message for the markets. It should limit any reversal of the portfolio balance effects described earlier, effectively putting reductions in asset holdings in the background for now as a policy instrument. As long as this approach is maintained, it would leave the adjustment of short-term interest rates as the more active policy instrument—the one that would carry the bulk of the work in tightening financial conditions when appropriate.

This approach is cautious in several dimensions. First, a decision to shrink the balance sheet more aggressively could be disruptive to market functioning. Second, a more aggressive approach would risk an immediate and substantial rise in longer-term yields that, at this time, would be counterproductive for achieving the FOMC's objectives. Third, the effects of swings in the balance sheet on the economy are difficult to calibrate and subject to considerable uncertainty, given our limited history with this policy tool. And fourth, policymakers do not need to use this tool to tighten financial conditions. They can tighten financial conditions as much as needed by raising short-term interest rates, offsetting any lingering portfolio balance effects arising from the still-elevated portfolio

Selling [assets] has more sympathy than you might think. It's more a question of timing and speed... Maybe you get in the second half of 2010 or something like that, if things are going pretty well, maybe then you'd sell a little bit at that point and you'd try to see how the market reacts and then you go from there. Some scenario that looks like that would be a more sensible way to think about how the committee might approach this. Let me stress, no decisions have been made but there has been a lot more discussion about it.

First, we have no shortage of tools for firming the stance of policy, and we will be able to unwind our actions when and as appropriate. Because we can now pay interest on excess reserves, we can raise short-term interest rates even with an extraordinarily large volume of reserves in the banking system. Increasing the rate we offer to banks on deposits at the Federal Reserve will put upward pressure on all short-term interest rates. In addition, we are developing and testing techniques for draining large volumes of reserves through reverse repurchase agreements and through term deposits at the Federal Reserve. And we can sell portions of our holdings of MBS, agency debt, and Treasury securities if we determine that doing so is an appropriate approach to tightening financial conditions when the time comes.

The key thing about any sales is that you do it very slowly in a very controlled manner. It would just be a matter of remaining active in the market for MBS securities and not a matter of hurriedly trying to sell off a big chunk of the portfolio. You wouldn’t want to do anything like that. That would be very damaging. But you could think about small amounts of sales that would help us get our balance sheet back to normal at an appropriate pace that would still provide a lot of support to the recovery. If you start to make some moves to go back toward normal, it is still an accommodative policy. You can take small steps as the economy improves.

...We’ve got to get {the FEd's balance sheet} to an appropriate size at an appropriate pace. This is a lot, more than doubling the monetary base. I don’t think it is threatening imminent inflation, but if you just leave it there without proper care you could get a lot of inflation out of that.

...I’d like to have {asset sales} be an option that we can entertain if the economy comes in pretty robustly in 2010. We could sell off a little. Not in the way that would upset markets, but in a way that would help us get to an appropriate sized balance sheet at an appropriate time.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.