When the Federal Reserve finally decides to begin draining cash from a flush U.S. banking system, policymakers may find themselves armed with more tools than they know what to do with.

In an effort to ensure its unprecedented monetary stimulus during the financial crisis would not create the risk of future inflation, the Fed has developed a broad range of measures to ensure an orderly retreat.

The Fed's exit toolkit is jam-packed with awkwardly-dubbed concoctions like reverse repurchase agreements and term deposits, along with more straightforward companions like asset sales and conventional interest rate hikes.

Even rate increases are more complex than before, since the Fed now has authority to pay interest on bank reserves parked at the central bank. That rate looks to supplant the overnight federal funds rate for a time as the one to watch.

With so many avenues before the central bank, the emergency exit lighting appears to have dimmed.

We haven't really settled on a roadmap, Richmond Federal Reserve Bank President Jeffrey Lacker told Reuters in an interview. The permutations are many. It's probably less important the exact sequencing we pursue than to make a smooth and clear transition.

For investors, the multitude of possible tightening combinations could make for a disorienting ride when the Fed does decide it is time to tighten monetary policy.

Market volatility, particularly in stock, bond and currency markets, could spike significantly, potentially crimping economic activity in a way that intensifies the effects of a monetary contraction.

Not that higher official rates appear imminent.

Fed Chairman Ben Bernanke made clear in his first-ever news conference last month that the Fed was not in a rush to tighten, reinforcing the central bank's vow to keep rates low for an extended period.

We think the up-and-down nature of the moderate expansion will keep the Fed from engaging in tightening moves this year, said Dean Maki, chief U.S. economist at Barclays.

But when the moment does come -- some analysts say it may even happen before the end of the year -- the Fed will face some difficult choices. Minutes from the Fed's April meeting, set for release next week, will likely show internal debate heating up.


With each move further into unconventional easing territory, the central bank added new potential layers to its exit strategy. The size of its balance sheet, for one thing, has more than tripled since before the crisis to an eye-popping $2.6 trillion.

And now that the Fed reinvests maturing mortgage bonds in its portfolio, a modest easing implemented last August, officials could kick off a round of tightening by simply allowing such proceeds to run off its balance sheet again.

Alternatively, the central bank could start by dropping its commitment to keep interest rates at exceptionally low levels for an extended period.

Even on this most basic of early stages in any tightening process, Fed officials have yet to come to a clear agreement.

They definitely don't have a roadmap or even a strategy, said Keith Springer, president of Springer Financial Advisors in Sacramento, California. This is all experimental and it contains more hope and prayer than experience that it works.

The New York Fed's open markets desk, which oversees daily market operations and would be in charge of implementing any exit plan, declined to comment for this article.


Early last year, before Europe's debt troubles derailed the U.S. economic recovery, talk of a Fed exit had been mounting. In February 2010, Bernanke laid out one possible sequence of steps for the Fed to take in an eventual push toward higher borrowing costs.

(It) would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, he told Congress in testimony. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates.

After that, the Fed would raise the interest it pays on bank reserves, providing a financial incentive not to lend if and when policymakers believe credit growth is running amok.

Given the weight of the Chairman's views, markets felt it was safe to assume his vision would prevail. Yet there is plenty of evidence of discord within the ranks.

Charles Plosser, the hawkish president of the Philadelphia Fed, would rather the central bank sell some of the mortgage debt it acquired during the crisis even as it raises benchmark interest rates. Other regional presidents have also shown a predilection for gradual asset sales.

Amid all the uncertainty, one thing is clear: the deeper down the road of unconventional policy the Fed treads, the more winding the exit path becomes.