How will Federal Reserve Pull Back Support?

This is a yesterday's headline from CNBC. I couldn't help laughing when I saw the headline.

As Economy Starts to Recover, Fed Weighs When to Pull Back (6/15/09, CNBC)

"As economy starts to recover..." When? The article says the Federal Reserve thinks it will be the 3rd quarter of this year, hopefully.

"The U.S. economy looks poised for a return to weak growth in the second half of the year and the Federal Reserve is giving careful thought to how to pull back its support when the time is right, Fed officials said Monday."

What is "weak growth"? Can you define that?

Amid the dribbles from the various Fed presidents, this caught my attention:

"Evans [Chicago Fed], a voting member of the Fed's policy panel, said some of the central bank's programs, especially those that provide back-up for short-term loans, will shrink naturally as market conditions improve.

"But he also said a "significant portion" of the Fed's balance sheet will likely not do so, which will force the central bank to develop what is likely to be a multi-pronged exit strategy."

Short-term loans will shrink naturally? Really? The Federal Reserve has been lending out U.S. Treasuries to the borrowers in exchange for whatever assets they can come up with as a collateral. The criteria for the collateral has gotton very loose over time, and the Federal Reserve has refused to discuss who the borrowers are, and what kind of collateral the Fed is getting.

So when the time is right, those borrowing institutions will gladly return the perfectly good Treasuries in exchange for the assets of dubious quality back onto their balance sheets.

Does that make sense?

"A significant portion" of the balance sheet that Mr. Evans refers to must be everything else but the short term loans:

Here are some major items on the asset side of the Fed's balance sheet. I don't think there has been any material change since May.

• Treasuries marked at face value: $622 billion
• Agency debt from Fannie and Freddie marked at face value: $84 billion
• Mortgage-backed securities guaranteed by Fannie and Freddie and Ginnie Mae: $427 billion
• Assets from various LLCs (Maiden Lane stuff, Bear Stearns, AIG) marked at "fair value" (or you could say mark-to-model, as there is apparently no market for them other than fire sale): $62 billion

Other than Treasuries, it's hard for me to believe that these assets could fetch a good price, or the price that the Fed wants to sell at (which I assume to be very very close to face value).

To remove excess liquidity, instead of reducing the asset side of the balance sheet, the Fed could try not to reduce the liability side, so that they don't need to sell the assets. I think that means excess reserve, which is currently at $816 billion. The Fed could raise reserve requirement for the banks, so that the banks will have to continue to park their money there. Or they could the combination of the two: sell some assets, and raise the reserve requirement.

However, raising the reserve requirement would mean loans that banks could make to businesses and consumers. How would that help the economy recovering weakly?

Any other options? I would like to hear from the Fed soon. If weak growth may be coming in the 3rd quarter, as the Fed says, that's July-August-September. July is less than a half month away.

Another day of quiet selloff in the stock market. The market doesn't seem to believe in "green shoot" all of a sudden. Dow Jones Industrial Average is down another 95 from yesterday, at 8,516. S&P 500 down almost 10, to 913. Nasdaq is down 15 to 1,801.

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