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.
The overwhelming majority of this cash ($822 billion) the Fed has put into the "system" has not made it into the "economy." It remains at the banks, which they simply deposit back at the Fed as excess reserves.
I make the distinction between the cash in the "system" and the "economy." The appropriate technical terms are "monetary base" for cash in the system and "M2 money supply" for cash in the economy. As we have noted, the monetary base is very large, it has not yet been converted to M2.
There was an initial 10% rise in M2 when this process commenced at the end of last year, but since then, the metric has been stagnant.
When M2 begins expanding again, it means the banks are ramping up loans and/or investments. It means the economy is returning to healthy activity, but it also becomes the point in time when the currently misplaced inflation fears become a legitimate risk.
During the course of 2009, the Fed balance sheet has sustained that ballooned size, but the composition of assets has changed. As the Fed's targeted intervention programs wind down, the Fed has kept the level of cash in the system consistent primarily by purchasing mortgage-backed securities.
When M2 begins to see signs of expansion, the Fed will use temporary measures to moderate the expansion. They will use reverse repos (temporary trades where they sell the security back to a bank for a predetermined time period) taking the cash out of the system.
The other tool is paying interest on those excess reserves currently parked at the Fed. Currently, those reserves are parked there for safety, earning almost no return. When the time to exit arrives, and the Fed begins to raise interest rates, it will become more attractive for some institutions to actually earn risk-free money from the interest the Fed will pay on excess reserves. Prompting the bank to convert some of that M2 back to excess reserves.
The benefit of temporary measures is they can be reversed quickly, should the economy stumble. I expect these temporary measures to be used for a considerable period of time, probably a couple of years, until the Fed believes the economy is stable. They will slowly, permanently drain the cash at a rate of a couple of hundred billion dollars per year.
For those who are concerned about the Fed's removal of accommodative monetary policy, the release of the September FOMC minutes earlier this week revealed the Fed debated expanding its MBS purchases. In other words, becoming even more accommodative.
For those who are worried about inflation and the dollar, while those concerns may be legitimate in the future, as long as the excess reserves remain at the Fed, in the "system" as part of the monetary base, those fears are premature. When the cash begins to be converted into M2 and gets into the "economy," that will be the time for the Fed to commence the exit strategy.
This article was written by Mike O'Rourke for TheStreet.com. The views and opinions expressed are his own and do not necessarily represent those of BTIG LLC. Mr. O'Rourke has no positions in the securities mentioned within.
Mike O'Rourke is chief market strategist for BTIG, where he advises the firm's clients on Market developments and provides them with "Market Intelligence." Mike's primary focus is identifying short-term catalysts driving daily trading activity and addressing how they fit into the "big picture." O'Rourke has 13 years of experience in the financial markets. He started his career on the floor of the New York Stock Exchange with specialist firm Spear, Leeds and Kellogg. At SLK, Mike transitioned to the Nasdaq as market maker trading technology stocks in the late 1990s. In 1998, he joined the Proprietary Trading Group, managing his own portfolio, and thereafter, he traded proprietarily for Goldman Sachs following its acquisition of SLK. In 2003, he joined one of BTIG's predecessor firms. In 2006, O'rourke was appointed as chief market strategist for BTIG.