I find it difficult to take talk of an “exit strategy” seriously when the Fed continues to purchase tens of billions of marketable securities.  Why can’t they wind down the MBS purchases early (scheduled to end in March at $1.25 TN)?  Apparently, the Fed’s immediate objective remains to ensure that markets remain highly liquid.  They may discuss various future methods to ensure that the massive liquidity pool does not turn inflationary, but the marketplace is not really fooled.  Markets see ultra-easy “money” indefinitely.

With gold back above 1,100 and crude in the neighborhood of $80, perhaps the Fed felt compelled to do something.  My own view (shared by many) is that they have no intention of implementing true tightening.  Their massive securities purchases have injected unprecedented liquidity into the system – and it will likely be years before these positions are reversed. 

I’ll assume that the Bernanke Fed is enthralled with the idea of an enormous liquidity cushion backstopping the system against future runs on banks, financial institutions, short-term financing markets, etc.  With over a Trillion dollars of “excess reserves,” there is today little fear of a renewed liquidity crisis.  Rather, worry revolves around the ramifications of the Fed moving to withdraw this liquidity bonanza or that these “reserves” might somehow fuel an inflationary lending boom.  It seems to me that the “academics” worry more about an inflationary surge while the markets worry more about the Fed reversing course and emptying the punchbowl.  So the innovative Bernanke Fed confronts an interesting challenge and delicate balancing act.

My hunch is that the Fed’s primary objective is to design new monetary doctrine and strategy that provides somewhat the appearance of traditional tightening but without any meaningful impact on its New Age Systemic Liquidity Backstop.  The Fed wants to maintain excessively liquefied markets, but at the same time convince the marketplace that they have this liquidity very well contained.  It’s there as a protective measure, and the Fed wants to ensure it doesn’t turn problematic.  The marketplace, generally fixated on liquidity and sanguine on inflation, is these days unusually receptive to avant-garde policymaking.

The Fed has signaled that it is essentially scrapping its previous policy of carefully managing a targeted “fed funds rate” – or essentially the overnight rate for the inter-bank/financial institution lending market.  Traditionally, the Fed would manage the fed funds rate to its target level by adding or subtracting system liquidity.  With the Trillion or so of Fed-induced excess reserves, it is no longer practical for the Fed to manage the overnight rate as it has in the past.  Time for new doctrine. 

The Fed certainly wants to avoid being in a position where it would have to withdraw huge amounts of liquidity to force the fed funds rate up to some targeted level.  And our central bank is very focused on not putting the funds market in a situation where imminent Fed liquidity withdrawal causes a fearful market to preempt the Fed.  At the same time, the Bernanke Fed certainly doesn’t want to get out of the business of manipulating market expectations. 

So the Bernanke Fed has apparently devised a new rate target – the rate it will pay banks on excess reserve holdings.  We’ll have to wait for additional details, as well as to see how this new monetary regime works in practice.  From what I’ve read so far, it has the appearance of a handy expedient; a tool similar in form to the fed funds target rate - but without the baggage of an implied policy of managing the rate through the addition or, more importantly, removal of Fed liquidity.  The Fed hopes to have the luxury of raising the rate it pays on reserves held at the Federal Reserve, without forcing the system-wide overnight funds rate higher.  The Fed would today certainly prefer to separate the tasks of raising rates and removing system liquidity and, once apart, implement respective “tightenings” at varying paces (rates up very slowly… liquidity removal even slower).

Certainly not without justification, the markets came to the recognition that yesterday’s increase in the discount rate did not signal any imminent tightening of financial conditions.  It will be interesting to see if the markets eventually end up calling a bluff on Fed “exit” policies more generally.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.