9. How will the Fed "sequence the exit"?

In theory, Fed officials have four choices for "exiting" from their current, highly accommodative stance: (1) terminating the current program of asset purchases, (2) draining excess bank reserves via reverse repos and/or term deposit facilities, (3) hiking short-term rates via parallel increases in the federal funds rate and the interest rate on reserves (IOR), and (4) selling assets outright.

In 2010, the main form of "exit" is likely to be an end to asset purchases. In addition, Fed officials will probably drain some excess reserves, mainly in order to prove to market participants that they are capable of doing so.5 In contrast, we expect neither a hike in the funds rate nor outright sales of assets on the Fed's balance sheet in 2010 (or for that matter in 2011).

10. Will the end to the asset purchases tighten financial conditions?

Possibly, although the degree is highly uncertain. Over the past 12 months, the Fed has bought a net $1.3 trillion in Treasury coupon debt, agency debt, and agency mortgage-backed securities, about three-quarters of the total amount of net issuance in these markets. These purchases are already diminishing and will likely stop by the end of the first quarter, while net issuance is likely to remain at levels similar to the recent pace through 2010. This means that non-Fed buyers will need to absorb a far greater amount of "flow supply" of securities.

This could put upward pressure on long-term interest rates. But two points are worth noting. First, our bond strategists' models do not find any misvaluation of US Treasury yields at present. If this means that the asset purchases didn't have a dramatic impact on the level of yields, it would suggest that end of the purchases might also not have a significant effect. Second, and presumably related to this, the policy shift away from asset purchases has been very well flagged and there are plenty of market participants who have a much darker view of the outlook for federal solvency than we do. For this reason, a sizable short base in the rates markets has been established in anticipation of the end to the Fed's purchases. This means that much of the impact may already be discounted in the current level of interest rates.

David Fuller's view I thought this was a useful report, sensibly measured in its conclusions, given the uncertainties which the authors acknowledge. However I am less sanguine on the subject of inflation. Like GS, I do not expect wage inflation. And while capacity utilization is high, it can also have a shelf life, rendering much of it unusable in future. For instance, what use can or will be made of former automobile manufacturing sites, now vacated?

My main concern regarding inflation centres on commodity prices. The Supply Inelasticity Meets Rising Demand story, so often mentioned by Fullermoney in the middle years of the decade, was only interrupted by the recession. My hedge against this risk is to maintain a number of long positions in commodities which remain in overall upward trends. Whether or not commodity inflation shows up in the official (often hedonic) data remains to be seen. However I think it will be reflected in the price of some household purchases. If so, the most serious of these, in terms of impact, would be the cost of energy and staple foods. I am more concerned about energy prices now that crude oil (weekly & daily) is back above $80, because the chart remains in a ranging uptrend.