Submitted by Edward Harrison of Credit Writedowns.
Over the past week, America’s banks have had a bumper earning season, in part courtesy of the Federal Reserve’s accommodative monetary policy. Even before this week, a number of market pundits (including me) began to wonder aloud whether the Fed had any strategy with which to remove all of the excess liquidity it has created to deal with the credit crisis. Finally, Ben Bernanke delivered the goods in an Op-Ed in today’s Wall Street Journal, signalling a decent overall strategy (including paying interest on reserves which I outlined here in “S.F. Fed chief Yellen tells inflationistas to pipe down”).
Most of the chatter started after yields on long-dated US treasury securities began to rise, with the 10-year hitting levels over 3.7%. I first mentioned this in my post “How will the Fed withdraw all that liquidity?” after Morgan Stanley’s David Greenlaw made some interesting comment in that regard. As to the specific tools the Fed intends to use, here’s how Ben Bernanke put it (I have added emphasis to the most important bits):
First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.
Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.
The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.
Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.
Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.
Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.
Given the “if necessary” label of the fourth item listed, you should expect Bernanke gave the list in exactly the order of which tools he would prefer to use. But, it should be clear to anyone that the Fed will err on the side of accommodation because it will be loathe to sink any incipient recovery given the dire economic misadventures of the past two years. And since monetary policy acts with a significant lag, inflation is likely to result. Of course, there’s always the pesky problem of all those risky assets now on the Fed’s balance sheet. But, let’s not quibble.
Bonds rallied today because market participants were relieved to find that the Fed had a coherent strategy to deal with the situation. Bernanke’s position as Fed chair is looking a lot more comfortable these days.
Update 2300ET: Just to be clear, I don’t think Bernanke’s strategy is any great shakes. It’s not credible to think the Fed can act with a 9-month time-lag, say, and still be able aggressive in withdrawing liquidity. And the Fed didn’t say anything about the toxic assets on its balance sheet. Nor do I think he said anything substantively or qualitatively different which makes me think the Fed would be able to tamp inflation down. But, that is irrelevant right now because all Bernanke needed to do is make a coherent, plausible exit strategy to meet or exceed expectations. And that is what he has done.
Source
The Fed’s Exit Strategy – Ben Bernanke, WSJ
Hugh 
Posts
Bernanke forgot to mention his fifth option:
I will arrogantly use all the authority endowed upon me by Congress in order to beg the Chinese and Russians to continue buying the junk paper that me and my fellows-in-crime bankers print here using our "secret technology". Furthermore, I assure the American public (a.k.a. "chumps") that I shall spare no embarrassment in order to make a buck for myself and my buddies I mentioned above. I shall even resort (as I already have) to prostituting my country's dignity, sell out the future of chumps' children everywhere, and even lie through my teeth, which I assure you I can de with such panache and savoir-faire, it's hardly noticeable anymore. Finally, I now command (and that’s an order, okay!) this chumpy American people I so despise to continue to blindly trust me simply because I deserve it.
That’s the Fed’s fifth option.
Vinny out…. in disgust.