The FED will first cease additional injections, than initiate withdrawals, and increase federal bond rate.

Question: What do you think about the current problems in the financial markets? Are they temporary or permanent? This question is of critical importance for the economic policy response that should be given. They require different responses. I would ponder on this question especially if I were in the shoes of central bankers of Turkey. Of course posing the question alone does not fulfill my duty. I am sure everyone there are aware, but I would like to summarize some important points. After all, a friend in need is a friend indeed.

The recent news from the Federal Reserve of the USA (FED) has shaken financial markets. The developments were generally read in connection with the policy step the FED is to take. But the FED already had declared these steps with its exit strategy two years ago in July 2011. The factor that has shaken the markets today was not even present back then. Naturally, as there was no phenomenon to deal with, there was not exit strategy in place. This factor seems to be missing in debates, especially in Turkey. This is highly odd, if you ask me. Financial markets have gone in turmoil after Bernanke’s remarks following the June meeting of the FED and the release of the meeting minutes. But both Bernanke and minutes refer mainly to the exit strategy discussed during the FED meetings dated 21-22 June 2011 and outlined in July 2011.

The phenomenon which was not present back then and has shaken markets lately is an obvious one: in September 2012 the FED declared that it will boost the market by buying treasury and mortgage-backed securities. The quantities for the purchasing operations were also announced. What has pushed markets into chaos lately was the statement that the FED will reduce buying bonds starting by the end of this year and will gradually cease the operation. But there was more on the story. Below are remarks from the exit strategy announced two years ago and still valid in essence as announced in the latest FED meeting:

First, the main reason that tripled the FED’s balance sheet in the post-global crisis period was that it bought extensive amounts of treasury securities and mortgage-backed assets. It did not get the payment for principles when these became due since it would cause monetary tightening. Instead, it reinvested them. In order to initiate the monetary policy normalization (this is the original phrase the FED used), the FED said, it will (likely) cease “reinvesting.” In other words, it will scale down its balance sheet and withdraw liquidity from the market.

Second, it will simultaneously or sometime thereafter will initiate reserve-draining operations (I am skipping the details) and hence prepare the markets for the implementation of increases in the policy rate (federal funds rate).

Third, when economic conditions allow, it will in the next step begin raising the federal funds rate.

Fourth, some time after the first increase in the rate, it will start selling the mortgage-backed securities which it bought to boost the market.

In its last meeting, the FED announced that it has decided to abandon the fourth step. This is good news for financial markets as the selling of the securities before due date implies that liquidity withdrawal would start earlier than anticipated. On the other hand, it was also stressed that the exit strategy declared in 2011 was still valid in its main framework. Of course the first step declared in 2011 is now the second one, the first being the one I quoted above that has lately pushed markets into chaos.

In conclusion the FED will 1) first cease additional injections 2) initiate withdrawals 3) increase federal bond rate 4) accelerate the withdrawal process 5) revise the plan under the light of new information. So, what do you think is the answer to the question above?

This commentary was published in Radikal daily on 13.07.2013