Federal Reserve Chairman Ben Bernanke this week delivered a more upbeat assessment of US economic prospects while – in response to questioning – repeating the mantra that very low official rates will be needed for an "extended" period. Markets, however, may be wrong to assume that this implies no policy tightening until late 2010 at the earliest.

The Fed's management of its balance sheet, indeed, suggests that a policy reversal has already started. The monetary base – currency plus banks' reserve balances at the Fed – has fallen by 6.0% over the last seven weeks. This reflects the impact of the "supplementary financing programme" (SFP) under which the Treasury issues additional bills and deposits the proceeds in its account at the Fed, resulting in a reduction in bank reserves.

Monetary base movements have recently led equity market fluctuations – see Andy Kessler's Wall Street Journal article and the first chart below.

The SFP is now up to $175 billion of a targeted $200 billion, suggesting that its negative impact on the monetary base will abate. The Fed, however, could request a further expansion of the programme or use other methods to continue to drain reserves, such as reverse repurchase agreements or auctions of term deposits.

In an earlier speech on the Fed's exit strategy, Chairman Bernanke suggested that the first stage of a tightening process would be a liquidity-draining operation designed to align market interest rates with the officially-set rate paid on reserve balances, currently 0.25%. The second stage would be a hike in the reserves rate. Consistent with this plan, the effective Fed funds rate has risen from a range of 0.10-0.14% in January and February to 0.20% as the monetary base has contracted – second chart.

The cautionary message for equities and other risk assets from the Fed's apparent policy shift is reinforced by a recent cross-over of G7 annual industrial output growth above real narrow money expansion – third chart. As previously discussed, global equities have underperformed cash by 5% per annum on average since 1970 when production has outpaced real M1, outperforming by 11% pa at other times.