U.S. Fed needs exit strategy from its massive stimulus

At a two-day meeting opening Tuesday, the Federal Open Market Committee (FOMC) is unlikely to announce any backing away from its stimulative policy, but will probably be making contingency plans, say Fed watchers.

“The Fed is cognizant of the need to sop up excess liquidity when the economic recovery gains traction,” said Liz Ann Sonders, chief market strategist at Charles Schwab & Co.

Sonders and others point out that the Fed, which has lowered its base rate to near zero and pumped more than one trillion U.S. dollars into the financial system, must be prepared to act to avert a dangerous inflationary spiral.

“Inflation builds partly from fear,” she said.

“Consumers and investors need to believe that the extraordinarily bold monetary and fiscal policies unleashed during this crisis will be reversed. If they don't believe this, inflation expectations will soar — as will interest rates — and policymakers will be in a real bind.”

Peter Hooper, economist at Deutsche Bank, said the Fed and chairman Ben Bernanke face a delicate balance in preparing an exit strategy that does not choke off recovery.

“Having engaged in unprecedented conventional and unconventional monetary expansion, the Fed's exit problem will be more challenging than usual,” he said in a note to clients.

“The exit is already under way inasmuch as balance sheet expansion associated with the Fed's liquidity facilities has been running in reverse for a number of months now.

Many of these facilities will run down further but are likely to be kept in place until the Fed begins to raise policy rates.”

Still, the Fed will probably avoid any mention of a reversal, said Scott Brown, chief economist at Raymond James & Associates.

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