slowed, longer - term interest rates have remained low, and mbs spreads over treasury yields have remained tight. this pattern suggests that the effects of the purchases have been primarily associated with the stock of the fed ’ s holdings rather than with the flow of its purchases. in that case, the market effects of the purchase program will only slowly unwind as the balance sheet shrinks gradually over time. 3 in my previous speech back in december, i discussed in detail the channels through which these market effects may arise. by removing large amounts of duration and prepayment risk from the market, the fed ’ s asset purchases reduced the volume of risk that the market had to hold, which lowered the risk premia on those assets. put differently, the purchases bid up the prices of those assets and hence lowered their yields. the lower levels of yields would be expected to boost other asset prices as investors substitute into alternative asset classes. these patterns describe what researchers often refer to as portfolio balance effects. such effects are important to consider, because they have implications for monetary policy. if the fed ’ s holdings of assets have produced lower long - term interest rates, the fomc has to carefully take into consideration how it will manage the size of its balance sheet going forward. in particular, a rapid and substantial reduction in our holdings of assets would likely push up long - term interest rates that is, it would put upward pressure on those rates by unwinding the portfolio balance effect. that increase in long rates would, in turn, weigh on other asset prices, reversing the positive effects that had been associated with the expansion of the fed ’ s balance sheet. under this view, the size of the fed ’ s asset holdings becomes a relevant policy lever. accordingly, this will be the first tightening cycle for which there are two broad policy decisions in play, as the fomc will have to set out not only the path of the short - term interest rate, but also the path of its asset holdings. the decisions on these two variables will have to be made in conjunction with one another to produce the desired outcome for economic activity and inflation. these considerations leave open a range of outcomes for how the two instruments will be used. in his february 10 testimony, chairman bernanke described a possible approach for managing the size of the balance sheet. in particular, he indicated that he does not currently anticipate that the fed will sell any of its asset holdings until the economic recovery is more firmly established and

reserves. note that the policy tightening in this scenario will still likely be taking place in an environment of large excess reserve balances, and the main workhorse of the tightening cycle will still be the interest paid on reserves. however, the draining tools can be used to best ensure the success of that framework. market conditions : at risk on exit? finally, let me turn to conditions in financial markets and discuss whether there may be vulnerabilities related to the fed ’ s exit from the current monetary policy stance. i think there are two potential areas of concern. the first potential concern is that the exit strategy could simply cause confusion among market participants, prompting volatility in asset prices. as noted earlier, this tightening cycle, when it arrives, will be more complicated than past cycles, as there will be more decision points facing policymakers. with more decision points come more opportunities for the markets to be confused by our actions. the recent changes to the discount rate and the treasury ’ s supplementary financing program balances highlight this concern, as the amount of attention that those actions received was outsized relative to their significance for the economy or for the path of short - term interest rates. the burden is on the fed to mitigate this risk by communicating clearly about its policy intentions and the purpose of any operational moves it might take. in this regard, the forwardlooking policy language that the fomc is currently using in its statement is important. i would argue that this language contains much more direct and valuable information about the likely path of the short - term interest rate target than does any decision about draining reserves. indeed, it will be difficult for market participants to make precise inferences about the timing of increases in the target interest rate from the patterns of reserve draining alone, in part some have discussed whether the draining of excess reserves has effects on the economy beyond the implications for short - term interest rates. in my view, it would be surprising if there were significant effects on the real economy or inflation associated with substituting one short - term, liquid, risk - free asset ( reverse repos or term deposits with the fed ) for another ( reserves ), except for the degree to which that substitution affects the fed ’ s control of overnight interest rates. because the fomc has not specified the path of reserves it intends to achieve before raising interest rates. the second potential concern that some may have is whether the markets have adequately priced in the exit strategy. however, a few considerations should limit