JPM - The art of the graceful exit

Even as the Fed remains low for long, policymakers will keep one eye on exit strategies. Even as the FOMC contemplates further increases in the size of the Fed balance sheet, careful attention will be paid to considerations of what is being called the exit strategy. While there is no authoritative definition of what is meant by the term, it can be taken to loosely mean, first, the steps needed to back away from unconventional policy, and second, the process by which the Fed returns to overnight interest-rate management as the principal tool of monetary policy. Each step taken to back away from providing unconventional support will constitute a de facto tightening of monetary policy

Ending liquidity programs is simple, though potentially painful; precise Fed control over the funds rates may be more difficult

Even with no further reserve tools, the Fed has powerful weapons to raise rates, in the unlikely event that this soon proves necessary. The basic idea behind using interest on reserves as an exit tool is to have the IOR rate serve as the Fed’s effective policy rate. In principle, banks would never lend out reserve balances at a rate below the IOR rate because they would be losing money on the trade relative to just leaving balances at the Fed and earning the IOR rate. The FOMC has stated an intention to keep rates low “for an extended period.” Now that the economy has moved from free-fall to controlled descent, the question of what an “extended period” means is becoming more interesting. Over the last 15 years, the dominant paradigm for understanding monetary policy has been interest rate rules and, in particular, the Taylor rule. In its simplest form, the Taylor rule says that the fed funds rate is set in response to deviations of inflation from a target inflation rate and of output from its full-employment, or potential, level.