IMF/Treasury Conference 

What is the FOMC trying to do with is asset purchases?

The FOMC’s asset purchases are intended to do what the FOMC always does 

when it wants to provide more monetary accommodation: It is using its policy 

tools to lower interest rates, improve broader financial conditions, and stimulate 

aggregate demand. So there is nothing unconventional in their motives.

So what’s “unconventional” about monetary policy today?

Normally, the Fed and other central banks set a target for a policy rate, typically a 

very short term rate, in the case of the Fed, the federal funds rate. To lower the 

policy rate the FOMC, for example, operates in the overnight repo market, 

carrying out open market operations by lending to or borrowing from banks, 

injecting or withdrawing reserves. This lowers the funds rate by injecting reserves

activating the portfolio balance process whereby investors first move into longer 

term Treasuries, then risk assets (corporate bonds and equities), and assets 

abroad, lowering the dollar. 

What is different today? Today the funds rate is near zero as a result of earlier 

conventional policy. As a result, to provide additional accommodation, the FOMC 

has to do its open market operations in longer term Treasuries. 

When they buy longer term Treasuries, they lower their rates, again activating the 

portfolio balance process. So this is the first difference from conventional policy: 

operating directly in long-term government securities market. The second

difference is that the FOMC is making outright purchases of Treasuries, rather 

than doing overnight operations in the repo market. As a result, asset purchases 

expand the Fed’s balance sheet. 
That leads us to the fourth difference: 

In normal times when the FOMC carries out operations by raising or lowering the 

funds rate, there are no costs doing so. However, the FOMC perceives there are 

costs associated with expanding the balance sheet. It therefore has to assess 

further purchasers, for example, under QE3, in terms of whether the benefits of 

further expanding the balance sheet exceed the costs. 

Here are the costs the Committee has identified. One of them relates directly to 

the topic of this conference: the liquidity in the government bond market. I will 

let Brian and David take up this topic. Second, the larger the balance sheet, the 

more challenging is exit. This increases the risk of a policy error, specifically not 

in time to contain inflation. Third, the Fed could face political backlash, if and 

when it realizes capital losses when sells assets, lowering (or even ending for a 

time) the Fed’s remittances to the Treasury. Fourth, and the cost that appears to 

be of most concern to the Committee today, is that, by lowering Treasury rates 

further, additional purchases would continue to incent investors to “reach for 

yield”, taking on more duration and credit risk than otherwise. Up to this point, 

this is exactly what monetary policymakers want to do. But carrying it too far, 

expanding the balance sheet too much, lowering rates too much can make 

financial markets very vulnerable to surprises, which, in turn, can result in very 

sharp movements in asset prices, threaten the recovery or worse, lead to large 

losses to individual investors, and threaten the health or even solvency of some 

financial institutions. 

 
How do you envision the Federal Reserve unwinding their portfolio? 

How will they unwind the portfolio? Easy! Very carefully, and learning along the 

way as they use operations and facilities they have never used before. 

Exit has several steps. The Committee has identified these steps in its “exit 

principles.” First, end the reinvestment program, beginning runoff that lowers the 

portfolio, beginning a passive tightening. Second, change the language to signal 

the dance toward the first rate hike is under way. Third, withdraw reserves by 

reverse repos and auctioning term deposits to ensure better control of the funds 

rate). Four, raise the IORE rate, to drag up the funds rate. Five, unwind their 

portfolio, normalizing its size, composition and duration. 

Until recently, the last exit principle was, unambiguously, to sell assets sometime 

after the first rate hike. The Chairman, in effect, yesterday revealed the updated

this exit principal. The FOMC will rely on runoff alone during the period the funds 

rate is being normalized, but keep the option open of later selling MBS to speed 

getting MBS off the Fed’s portfolio and returning to an all Treasury portfolio.