A Perspective on Possible Fed Exit Strategies 2013-08-02
Federal Reserve Bank of St. Louis
the best exit strategy is to reduce the Fed’s portfolio to a level that will allow the FOMC to return to its practice of interest rate targeting used prior to the Lehman Brothers bankruptcy in mid-September 2008. This strategy could be accomplished either through outright sales or by continuously rolling over reverse repurchase agreements. The effect on the balance sheet is the same regardless of the method used. However, the FOMC might use a combination of reverse repurchase agreements and outright sales as was commonly done to expand the balance sheet to meet the needs of a growing economy.
The downside of this strategy is that bond prices fall as interest rates rise. Hence, the Fed could suffer a capital loss—that is, receive a lower price for the securities when they are sold than when they were purchased. The possibility of the Fed suffering significant capital losses is mitigated by the fact that many of the securities were purchased when bond prices were much lower (i.e., bond yields were much higher). This means interest rates would have to rise somewhat before any capital loss on such bonds would be incurred. The likelihood of significant capital losses could also be reduced by selling longer-term securities and simultaneously purchasing short-term securities in advance of reducing the overall size of the Fed’s balance sheet.
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