Economist’s Corner: The Fed "Exit" Strategy


The Fed’s “Exit” Strategy

Written by: Dr. Lynn Reaser

Through its aggressive actions, the U.S. Federal Reserve helped prevent a complete meltdown of the global financial system and a worldwide depression.  Two years after the start of major financial problems and one year after the failure of Lehman Brothers, Wall Street is starting to come back to life and Main Street is seeing a little more credit at lower interest rates.

The aggressive steps taken by our monetary authorities have included slashing interest rates to near zero, pumping reserves into the banking system, and directly assisting corners of the financial markets under particular stress.  Because of the importance of housing, the Federal Reserve has been particularly active in boosting the flow of mortgage money to homebuyers.  The Fed has committed to purchase $1.45 trillion of debt either issued or guaranteed by the government housing finance giants–Fannie Mae, Freddie Mac, and Ginnie Mae.  These purchases have helped drive the cost of 30-year fixed rate loans down to just over 5.00% from more than 6.00% a year ago.

At its meeting last week, Federal Reserve officials issued a relatively upbeat, albeit cautious, outlook on the U.S. economy.  The Fed’s official statement indicated that its target federal funds rate is likely to remain close to zero for some time, but that it will be looking to gradually withdraw the various support lines it has given various parts of the economy.  Specifically, it will stretch out its mortgage support program by three months to the end of March 2010, but that this special credit spigot will be shut off at that time.  The Fed hopes that private investors will have enough confidence to step up to the plate and buy mortgage securities by that point.

Monetary officials know they will need to withdraw the massive stimulus they have supplied the economy during the past two years or inflation will mount.  The implementation and timing of that removal will be difficult and tricky.  The “exit” strategy could be as least as challenging as the “fix-it” strategy.

For the text of the policy statement issued by the Federal Reserve’s Open Market Committee following its September 23, 2009meeting,see http://www.federalreserve.gov/newsevents/press/monetary/20090923a.htm

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