For now, the US Federal Reserve is continuing its purchases of assets primarily treasuries and mortgage-backed securities at a rate of $85 billion a month, but purchases are expected to start to be wound down as early as September. The plan is to get back to pre-financial crisis monetary policy: that is, shrink the Feds balance sheet and revert to using the Fed Funds Rate to signal the Federal Open Market Committees policy stance. When the Fed begins tightening at some point in 2015 after ending quantitative easing, possibly in less than a year from now, it will be confronted with the unprecedented problem of what to do about the estimated $4 trillion of assets it will have accumulated on its balance sheet. With all that liquidity it pumped into the economy washing around, the Fed risks being unable to attain higher real interest rates if it does not unwind its holdings of treasuries and MBS. But to achieve its stated aim of returning monetary policy to its pre-financial crisis position entails getting rid of an eye-watering $3.2 trillion of these assets. The Fed could simply sell the assets, but the sheer scale of the proposition, given that Fed reserves total only around $50 billion, exposes it to the risk of substantial capital losses. QE3 means the Fed will have $1.65 trillion more assets to shift than it expected back in 2011 when disposal was first discussed, and will probably receive less than it paid for them a problem that will worsen as the supply of these assets and interest rates rise. The Fed projects that 10-year yields would need to reach only 4% by the end of 2015 for the $250 billion unrealized gain it has accumulated between 2009 and now to turn into a $350 billion loss. With all this is in mind, the Fed has increasingly been experimenting with reverse repos as a means of draining funds from the financial system quickly, without unloading huge volumes of treasuries from its balance sheet directly into the market. The Fed borrows money with treasuries and MBS as collateral through auctions conducted with primary dealers. The dealers bid with the interest rates at which they are prepared to lend to the Fed. According to Capital Economics, measures to drain liquidity from the banking system and raise the cost of money could be less than 20 months away. However, to substantially affect the level of funds in the banking system, these reverse repo operations would need to be conducted on a greater scale and over a more extended period than has ever been attempted in the history of US monetary policy. Capital Economics senior US economist, Paul Dales, says: Theres a strong chance reverse repos and the term deposit facility will be used in the Feds exit strategy at some point. Theyre in the Feds toolbox and the fact its testing them out does suggest theyre quite keen on these tools as a way to extract liquidity from the markets. He adds: The way theyll be used is to make sure that when the Fed wants to raise interest rates that market rates are actually tied to the Fed funds target rate. The problem at the moment is theres so much liquidity in the market that theres a lot of downward pressure on effective, or actual, interest rates such that even if the Fed came out tomorrow and said it wanted to raise the target rate, its by no means certain that the effective interest rate would rise with it. The Fed funds rate the interbank rate for overnight lending of funds banks hold on reserve at the Fed is adjusted through the Feds open market operations regulating the supply of reserves. When the Fed sells treasuries these reserves are reduced as the Fed makes a withdrawal from the account held at the Fed by the dealers bank. Absorbing banking system reserves in this way spurs banks to raise the interest rates at which they lend. However, raising the cost of money also exerts downward pressure on inflation something the Fed might be wary of given the difficulty it is currently experiencing in trying to spark inflation in the economy. US inflation rose to 1.8% in June from 1.4% in May, but still remains below the target of 2%. When fuel and food inflation are stripped out, consumer price inflation was up just 0.2%. Reverse repos offer the flexibility that they can be rolled over so that the funds borrowed by the Fed remain out of the financial system until the assets mature. Conversely, if the Fed needs to react quickly should the recovery falter, the contracts can be allowed to expire, injecting liquidity back into the system in short order. The counterpoint is for the Fed to simply hold the assets on its balance sheet to maturity. Despite the duration of the Feds portfolio increasing sharply in the current round of QE it is still just 6.5 years. However, the plan could come unstuck should the Fed need to dispose of assets to counter a sudden surge in inflation. Lombard Street Researchs view is that the Fed will err strongly on the side of caution, given how mere talk of tapering has pushed up long-term rates, to avoid a sharp 1994-style rise in bond yields when Fed tightening resulted in widespread destruction to bond and currency markets. The bigger issue is how do you signal how much you want to sell off and how they are going to work out the pace at which they try to reduce their balance sheet, says Dario Perkins, director of global economics at Lombard Street Research. How do they stop markets from suddenly pricing in all these assets that are going to be sold? The Fed has struggled in previous turns in the interest rate cycle with signalling how much its going to change interest rates and this situation could be even more difficult. It may be that they just dont sell off these assets because the easiest way to exit is just to start by raising rates. If you take the size of the balance sheet as given then the overall amount of stimulus being provided to the economy is the balance sheet plus the [low] level of interest rates. The easiest way to curb that is to start by raising rates to a neutral level before taking them to a higher level. But that could be years away, Perkins concludes, by which time much of the assets will have expired as it comes off the Feds balance sheet at maturity. Whatever policy tool the Fed seeks to deploy, market fright at the mere talk of tapering and confusion over the pace of stimulus withdrawal suggests the US central bank faces an uphill battle to explain its exit strategy to market participants.