Supply-side investment research firm Laffer Associates recently published a paper on "The Fed's Exit Strategy: Possibilities and Limitations," which "takes a deep dive into the Fed's monetary policy toolbox to find out how the Fed most likely would attempt to prevent its ballooning balance sheet from igniting inflation, and illustrates possible policy limitations." The summary says, "The U.S. banking system sits on about $1 trillion in excess reserves.... There is no single, simple solution for the Fed to successfully drain $1 trillion from the U.S. banking system or convince the banking system that it's optimal to hold huge excess reserves, and inflation risk remains elevated."

Economist Kenneth Petersen writes, "Milton Friedman got it right and Keynesian Phillips-curve economists got it wrong: Sustainable inflation is always and everywhere caused by too much money chasing too few goods. Fast forward to today's monetary environment, and everyone should be concerned about inflation, big time.... The Fed knows this and is cramming to come up with an exit strategy that removes excess reserves from the banking system (asset management) and locks-up reserves (liability management) prior to when the 'too much money chasing too few goods' scenario is upon them. Several tools are available to the Fed, but no silver bullet exists as political and technical concerns prevail. Initially the Fed would attempt to smoothly remove excess reserves from the banking system and attempt to convince banks to keep reserves tied up at the Fed, but should those attempts fail, the Fed would pull out all the stops and force banks to keep large reserves parked at the Fed."

He continues, "In tri-party term reverse repos, the Fed sells an asset and promises to purchase the same asset back at a later date and at a higher price. A custodian bank -- like Bank of New York Mellon and J.P. Morgan Chase -- acts as an intermediary between the parties involved in the repo transaction, which collects collateral and marks-to-market. By engaging in tri-party term reverse repos, the Fed theoretically would be able to drain several hundred billions from its balance sheet for up to two years, which is the typical length of term repos. The Fed also could attempt to engage in tri-party open reverse repos, but these could be much harder to find counterparties for."

Petersen says, "To drain, say, $500 billion from its balance sheet, the Fed could split the collateral between Treasury securities and AAA-rated agency MBS, and most likely be able to successfully clear both of these trades. Although, the Fed likely would have to engage in these tri-party term reverse repos with more counterparties than just its usual primary dealer counterparties -- as the primary dealers may not have the interest or the liquidity to engage in large trades. These other counterparties would be money market mutual funds, but also could be government sponsored enterprises.

He explains, "The $3.3 trillion money market mutual fund industry would kill for just a little more yield currently, and as long as that hunger for yield at almost any cost persists, the Fed would have an eager counterparty to engage with in the money market mutual fund industry. Besides, the money market mutual fund industry may feel obliged to help out the Fed since the Fed provided a safety net under the industry during the credit crisis by establishing the money market investor funding facility and the asset-backed commercial paper money market mutual fund liquidity facility."

Finally, Petersen writes, "While these operations would drain the Fed's balance sheet of potentially hundreds of billions, they also would be associated with upward pressure on the effective Fed funds rate. So while the target Fed funds rate set by the FOMC would remain unchanged, the effective Fed funds rate would drift upward. This could convince banks to increase their prime interest rate, which again would make home equity lines of credit, credit card loans, car loans, and student loans more expensive. The risk of pushing the effective Fed funds rate well beyond the target funds rate, could restrain the Fed's ability to engage in large tri-party term reverse repos. Nonetheless, the Fed would likely start engaging in such trades in the first half of 2010."

To request a copy of the Laffer paper, e-mail Ken Petersen or Pete Crane.

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