>The Fed’s road home (JP MORGAN)

• The exit from exceptional financial market support is under way
• The exit from exceptional macroeconomic support won’t begin until 2011
• Reserve draining will serve as an adjunct to interest rate policy
• Long-run changes to monetary policy framework will be limited

Understanding Fed policy during the past two years has required a comprehension of the detailed mechanics of central banking. Over the next 12 months, a knowledge of this “plumbing” of central banking will still be essential for making sense of the monetary policy outlook. However, as the prospect for positive interest rates begins to reappear on the horizon, some of the more traditional questions regarding interest rate policy will also reemerge.

The following report builds on a series of special studies we have provided through the crisis—beginning with “The Fed’s big bang” in April 2008—that attempts to guide readers through the increasingly complicated thicket of Fed policy considerations. The first half of this report looks at the technical aspects of the move away from balance sheet policy and back toward interest rate policy. Bank reserves and the overnight money market figure prominently in this section, as the “draining” of reserves is a fundamental aim of the exit strategy. The second half of the report deals directly with interest rate policy, including which rate(s) will be hiked, when, and how fast. We conclude with some observations about the longer-term future of the Fed.

Before turning to a discussion of central bank plumbing, we briefly preview what we see as the most likely evolution of the timing and sequencing of Fed moves toward the exit.

To read the full report: FED POLICY