The Fed is likely to decide this week to continue the bond-buying program comprising the third quantitative easing, or QE3.
The next issue is how to exit the strategy when the time comes in a way that doesn’t thrust hyperinflation into the mix.
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The Fed has been expanding its portfolio of assets with each quantitative easing. The exit strategy of 2011 calls for the Fed to start selling the additional assets by mid-2015.
The selloff could be quick enough and large enough to spike interest rates and threaten the health of the economy.
At the December 11 and 12 Federal Open Market, the Fed will have to weigh the decision to continue QE3 carefully. The larger the Fed’s portfolio, the larger the ultimate sell-off will be.
The Fed announced its planned exit strategy in 2011 to ward off investor fears that the actions would ignite rampant inflationary pressures.
The first step in the exit process would be to allow assets to mature without being replaced. This process will now be slower since the average duration of the Fed’s holdings has been extended.
The next step would be to modify the length of time it intends to keep interest rates near zero. It would also begin to temporarily drain excess bank reserves.
Then the Federal Funds Rate would be raised. Lastly, securities would be sold.
During the decade before the crisis, the Fed’s balance sheet comprised 6.3% of the US gross domestic product (GDP).
Today, that would equate to approximately $995 billion instead of $2.86 trillion. The current exit plan
would require selling almost $2 trillion worth of bonds over a three-year period. If another $1 trillion in assets are added, that number would jump to $3 trillion over the same time period.