Large expansions of the balance sheet can complicate exit strategy, when that becomes appropriate. While the Federal Reserve has a variety of tools designed to tighten policy, either by raising interest on excess reserves, removing reserves, or selling securities, some of these tools have not been used in the past. Naturally this makes the exact impact of various tools somewhat more uncertain than normal. Still, I am very confident of the Fed’s ability and will to exit, when necessary.

You know, I think there's sorta two sort of critiques of the large scale asset purchase program. One, it won't be effective. It doesn't do that much. And-- and we agree with that, that we don't think that this large scale asset purchase program's going to have a huge, powerful effect on-- on the U.S. economy.

And two, I think there's a lotta concern about exit. Once-- when the time comes and the U.S. economy finally does pick up speed and inflation starts to rise, will we-- will we be-- will-- will-- will we be able to exit from this program smoothly without a long term inflation problem? And I think the answer to that second question is really critical. And our answer to that question is very much yes.

I think people do not understand clearly-- and this is partly on us to communicate clearly our ability to manage this when we actually exit -- we can have an enlarged balance sheet and not have an-- a long term inflation problem.

But risks remain, especially those associated with inadvertently creating false expectations that the Fed is preoccupied with achieving a specific level of the unemployment rate. Our ability to manage those risks will depend on when and how we choose to tighten policy, as eventually we must. To wait until unemployment reaches some predetermined level, as the Martin FOMC did in the 1960s, is likely to mean waiting too long. That strategy proved bitterly disappointing for Martin and his colleagues, and I expect it would prove disappointing for us as well. At some point in the not-too-distant future, we are likely to face an economy growing in a self-sustaining way while the unemployment rate is still relatively high by historical standards. The decisions we make at that time will be the true test of whether we've learned our lessons.

[W]e should get our balance sheet back down to less than a trillion dollars to allow us to engage in short-term securities transactions.

What stage are we in now? I would say we are, in different forms, in an exit stage... [The Fed has] for quite some time now (been) exploring the exit, describing the exit from the liquidity facilities and differentiating that from exit from our core monetary policy functions.

On reverse repos, we have already successfully run small-scale operations using Treasury and agency debt as collateral with primary dealers. However, that leaves two significant steps still to take in preparing the tool. One is developing the capacity to use our MBS holdings as collateral. Work in that area is nearly complete, and we will likely conduct some small-scale operations with MBS collateral in a month or so to exercise that capability. The other step is expanding the set of counterparties that we use for such operations. Earlier today, we published criteria for money market mutual funds to become eligible to participate in reverse repo operations, which was a first and important step in that direction. We are currently working with other types of firms to assess their potential participation in the program, as well. Our expectation is to have arrangements in place and to be ready to transact with some non-dealer firms by the end of the second quarter. This expansion of counterparties is important for boosting the capacity of the program.

"We made a very small technical change" by raising the discount rate, Dudley said. "The action yesterday was really an action about the improvement in banks" and reflected that these institutions no longer need this emergency source of cheap funding the way they did during the depths of the financial crisis, the official said.

The discount rate increase "is not at all a signal of any imminent tightening" in monetary policy, and the Fed's commitment to keep rates very low for an extended period "is still very much in place," Dudley said. He added any increase in the short-term rates that affect the economy is "off in the future."

As reported by Dow Jones Newswires

Earlier today, the Fed announced an increase in the primary credit rate. The primary credit rate—also called the discount rate—is the rate at which the 12 Federal Reserve Banks across the country provide temporary liquidity to healthy banks. How should today's announcement be interpreted? I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent. Rather, this action should be viewed as a normalization step.

To promote a clearer distinction between monetary policy and fiscal policy and to help safeguard the Fed's independence, I advocate that we implement monetary policy using a portfolio that contains only Treasury securities, preferably concentrated in bills and short-term coupon bonds. Like Ulysses and the Sirens, the Fed could help preserve its independence by limiting the scope of its ability to engage in activities that blur the boundary lines between monetary and fiscal policy. Thus, as the economic recovery gains strength and monetary policy begins to normalize, I would favor our beginning to sell some of the agency mortgage-backed securities from our portfolio rather than relying only on redemptions of these assets. Doing so would help extricate the Fed from the realm of fiscal policy and housing finance. It will take some time for the Fed's portfolio to return to its pre-crisis composition, but we should begin taking steps in that direction sooner rather than later.

One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves.

I don’t think that we have an exit problem. I think that we’re going to be able to manage our balance sheet down very, very smoothly. We have a new tool – the ability to pay interest on excess reserves, which means that the growth of our balance sheet is not going cause a problem in terms of future inflation. But other people have different views. And so the bigger our balance sheet gets the more people worry about that potential consequence. If that caused people to be worried about the inflation outlook, that would be counterproductive to our goals in terms of monetary policy.

[A]s our agency mortgage-backed securities purchases come to an end, we’ll probably see a little bit of upward pressure on interest rates. But there’s a big debate about whether they’ll be small or medium or large. So I think we’ll have to wait and see. Obviously, if mortgage rates were to back up a lot and if that had a big consequence for the economy then we very well could rethink the issue about whether we wanted to buy more mortgages.

Gharib: What is considered a lot?

Well I think we’re going to have to see the circumstances at the time. But most people who’ve thought about what’s likely to happen when we pull back from purchasing mortgage backed securities… they’re thinking that this is going to have a relatively small effect on the level of mortgage rates… something on the order of ½ to ¼ percent.

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, said the central bank should end its purchases of mortgage debt as planned in March because the private market for the securities is “healing.”

[I]f necessary, we always have the option of reducing the size of our balance sheet by selling some of our securities holdings on the open market.