“To many observers, the Federal Reserve’s extraordinary policy actions during the recent crisis averted a financial Armageddon and curtailed the depth and duration of the recession (Rudebusch 2009). To combat panic and dislocation in financial markets, the Fed provided an enormous amount of liquidity. To mitigate declines in spending and employment, it reduced the federal funds interest rate—its usual policy instrument—essentially to its lower bound of zero. To provide additional monetary stimulus, the Fed turned to an unconventional policy tool—purchases of longer-term securities—which led to an enormous expansion of its balance sheet.

As financial market strains eased and economic recovery began, discussion turned to how the Fed would unwind its actions (Bernanke 2010). Of course, after every recession, the Fed has to decide how quickly to return monetary conditions to normal to forestall inflationary pressures. This time, however, policy renormalization is especially challenging because of the unprecedented economic conditions and Fed actions. This Economic Letter describes various considerations in formulating an appropriate policy exit strategy. Such a strategy must unwind each of the Fed’s three key actions: the establishment of special liquidity facilities, the lowering of short-term interest rates, and the increase in the Fed’s securities holdings.” Read more.