Balderdash's  Instablog

To the external borrower, whether it be the treasury or the public, the result of using either tool is the same: higher interest rates. Given the political pressure to get the economy 'booming' again, we're essentially propping up industries that need to and would otherwise shrink given a higher cost of borrowing (housing for instance). Therefore, whether the fed controls interest rates via open market operations or via internal deposit interest, Bernanke risks choking off the growth fueled by his inflation and causing another nasty recession. This would include raising borrowing costs for the massive federal deficit, a political move that would probably get the fed's charter revoked. 

I think the problem with an exit strategy using bond sales is that the bonds he has to sell are junk and he probably can't sell them on the open market for their balance sheet value -- so if he gets $0.1 on the dollar he can't soak up the extra money he sent out paying par for them. The fed therefore creates a back door for soaking up liquidity -- competing with private borrowers on excess reserve loans -- which will keep the fed balance sheet permanently expanded and hopefully draw a 'pig pen' around the excess reserves so they can't escape. The problem with this is that the higher the interest rate goes, the more money Bernanke has to print to pay interest on the reserves, which is essentially going to create a compounding of excess reserves, a runaway problem. In fact, it seems possible that the banks will lend to noone, with Bernanke paying the bank operating costs through inflation, if he sets the interest rate high enough.

The only way out is to actually DESTROY the excess reserves, through bond sales (which he can't) or via the hand of god (a large fee), which would anger his banking constituents since they wouldn't be getting bonds out of it (it would be like the bank just whimsically lowering your checking account balance).

My conclusion, therefore, is that this is no exit strategy at all, but just another layer of confusion slapped on the public to allow for backdoor inflation and deficit financing.