The Fed Inches Toward the Exit

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"The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets," policymakers wrote.

Leading up to the decision, there had been speculation the FOMC might detail a formal separation of its monetary and liquidity policies, and in essence this came to pass with a new paragraph broken out to detail the finite timeline on several emergency facilities: "In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve's special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve's announcement of June 25, 2009." Among the alphabet soup of plans affected: the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility.

Liquidity Operations

The Fed also said it will be working with its central bank counterparties to close its temporary liquidity swap arrangements by Feb. 1. It added that it expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and Mar. 31, 2010, for loans backed by all other types of collateral.

"The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth," the note added.

This may have been included as a preliminary step toward unwinding accommodation in an attempt to mollify the committee's inflation hawks, given the still-accommodative policy stance. Indeed, the FOMC has allowed several of its liquidity operations to begin to run off, and has begun conducting reverse repo tests in preparation for further liquidity drains.

There was even speculation that the Fed could nudge up the primary credit (discount) rate and discuss other policy tools, though no such changes were evident at this time. No changes were made to its asset purchase programs, with the Treasury buyback completed. Agency purchases are to be wound down in the first quarter with purchases of "about $175 billion," as before.

Recovery's Headwinds

But still-significant headwinds were noted until the recovery becomes self-sustaining. Despite the evident recovery in the housing and equity markets that have supported a real improvement in household wealth, liquidity and cash remain king into yearend, reflected in the steepening yield curve and sovereign credit angst. The Senate Finance Committee confirmation vote for Bernanke's second term is set for Dec. 17, though a full vote may be postponed a month. The Fed chief was since voted Time magazine's Person of the Year and despite public angst toward the Fed, confirmation will likely be a mere formality even as Bernanke continues to fight for Fed independence.

Market reaction was fairly restrained on Dec. 16, as Treasury yields bounced moderately after the Fed statement largely hit all the expected policy buttons. The 2-year note had rebounded to 0.84% prior to the decision and held there, while the 10-year yield bounced 4 basis points toward 4-month highs of 3.62% again, compared with session lows of 3.54%. The dollar index initially dove lower, but rebounded above 77.0 as the Fed's escape plan crystallized a little. Equities wilted toward the close after an initial jag higher.

While the Fed retained an exceptionally accommodative stance to support the economic recovery, and remained in no mood to prematurely stifle progress before the end of the year amid renewed global credit jitters, it has clearly laid out a path for change next year. Reductions in extremely low rates may still be some way off, but natural attrition of its emergency liquidity facilities will be the primary vehicle to begin to snug up monetary policy in 2010, assuming there continues to be no major growth relapse or exogenous event risk that interrupts those plans.

Wallace is global investment strategist for Action Economics .

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