The recession is now over and the US economy is recovering. To deal with the crisis, the Federal Reserve followed an unusually aggressive monetary policy expansion – cutting the Federal funds rate from 5.25 per cent in August 2007 to close to zero by the end of 2008, and introducing unprecedented quantitative easing with its purchases of mortgage-backed securities and Treasury securities.
The question of the moment is the Fed's exit strategy: when will it shift from its highly expansionary policy to a neutral one consistent with long-run growth and low inflation? Ben Bernanke, the Fed chairman, has recently announced steps to disengage from expansionary policy, including the termination of MBS purchases at the end of March and measures to drain reserves from the banking system.
The key question, however, is: when will the Fed start raising the Fed funds rate? The timing is fraught with peril. Tightening too soon risks pushing the economy again into recession. Waiting too long risks firing up hard-to-reverse inflationary expectations.