Bernanke’s How-To on Rate Increase Lacks a When

Bernanke’s How-To on Rate Increase Lacks a When
By SEWELL CHAN
Copyright by The New York Times
Published: February 10, 2010
http://www.nytimes.com/2010/02/11/business/economy/11fed.html?ref=global-home


WASHINGTON — “At some point.” “At the appropriate time.” “When the time comes.”

On Wednesday, the Federal Reserve’s chairman, Ben S. Bernanke, outlined a strategy — but not a timetable — for scaling back the extraordinary measures it began taking in 2007 to prop up the economy as financial markets teetered on collapse.

The Federal Reserve has eased borrowing by lowering short-term interest rates to nearly zero and built up a $2.2 trillion balance sheet by scooping up assets like mortgage-backed securities and vast sums of Treasury bonds and notes.

Eventually, to avoid inflation, both actions will have to be reined in. But Mr. Bernanke, in a 10-page statement, provided few hints as to how long that period will be.

“Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding,” he wrote. “We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively.”

However, Mr. Bernanke did provide new details of a major concern: how, as the recovery proceeds, to gradually shrink the balance sheet, which along with a vast array of assets also includes $1.1 trillion that banks are holding with the Fed.

Mr. Bernanke suggested that a new policy tool — the interest rate on excess reserves, which the Fed began paying in October 2008 — would be a vital part of the Fed’s strategy.

Increasing that interest rate, he said, will have the effect of pushing up other short-term interest rates, including the benchmark fed funds rate — the rate at which banks lend to each overnight.

It is even possible, Mr. Bernanke said, that the Fed “could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities,” to communicate its policy stance to the markets. Since 1994, the fed funds rate has been the much-watched centerpiece of statements by the Federal Open Market Committee, the Fed’s crucial policy-making arm.

For days, economists have been trying to forecast what Mr. Bernanke would say about the sequence of steps and the combination of tools the Fed will use to tighten credit. On that subject, Mr. Bernanke offered only hints of his thinking.

“One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation,” he wrote. “As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves.”

But Mr. Bernanke suggested that “if economic and financial developments were to require a more rapid exit from the current highly accommodative policy” — that is, if fears emerge about inflation — the Fed “could increase the interest rate paid on reserves at about the same time it commences significant draining operations.”

Along with raising the interest rate on reserves, Mr. Bernanke discussed three other options for draining reserves. The first involves reverse repurchase agreements, in which the Fed would sell securities from its portfolio with an agreement to repurchase them at a later date.

The second involves term deposits — similar to certificates of deposit — to banks. That would convert part of the banks’ reserves into deposits that could not be used for short-term liquidity needs and would not be counted as reserves.

A third tool involves redeeming or selling securities. That strategy could carry risk, as the Fed’s large portfolio of mortgage-backed securities is helping to prop up the housing market and keep mortgage-interest rates low.

Mr. Bernanke did note that the balance sheet would shrink a bit on its own, over time, as assets like mortgage-backed securities and debt guaranteed by Fannie Mae and Freddie Mac are prepaid or mature. “In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities,” he wrote.

Mr. Bernanke also reviewed the controversial lending assistance it extended to “help avoid the disorderly failure” of Bear Stearns, which was sold to JPMorgan Chase, and the American International Group, which was bailed out by the government. Mr. Bernanke said that the credit extended under those arrangements totaled about $116 billion, or about 5 percent of the balance sheet.

“These loans were made with great reluctance under extreme conditions and in the absence of an appropriate alternative legal framework,” he said, emphasizing that he did not believe that the loans would result in any losses to taxpayers.

The statement was prepared for a House committee hearing that had been scheduled for Wednesday but was postponed because of snow. Mr. Bernanke decided to release the statement anyway.