Federal Reserve's Exit Strategy Simplified

NEW YORK (TheStreet) -- Last week Fed Chairman Ben Bernanke's speech titled the Fed's Balance Sheet Update provided further clarity on the Fed's exit strategy from its aggressive policy intervention. Notable improvements have materialized in the financial markets over the past six months, but as is typical during a recovery, the improvements in the "real" economy have lagged. Market gains can be fleeting and don't do much for the nearly 10% of Americans who are unemployed, therefore the "real" economy is the higher priority.

At the end of last year, the Fed ramped its balance sheet up from $800 billion to approximately $2 trillion. This has been at the root of many of the inflation and weak-dollar fears pervasive in the market today.

The simple explanation of the influence of the Fed's balance sheet on the market is as such: When the Fed buys a security, cash is given to the seller and hence is now in the "system." The asset then sits on the Fed's balance sheet.

Normally, the Fed sells one asset to purchase another, keeping the cash in the system neutral. The past year has not been normal, so to combat deflation, the Fed has created new cash to purchase assets.

While that cash goes into the "system" it does not automatically go directly into the "economy." That cash winds up in the hands of the bank who sold the Fed the asset. To get into the "economy," that bank must then either lend it out or directly invest it.