NEW YORK – Economic conditions should “warrant exceptionally low levels of the federal funds rate for an extended period,” Federal Reserve Board Chairman Ben S. Bernanke planned to tell Congress today, but added that as the economy expands monetary policy will tighten.
“The FOMC anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. In due course, however, as the expansion matures the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures,” text of testimony Bernanke planned to tell the House Committee on Financial Services. The testimony has been postponed due to inclement weather, but the rext was released by the Fed.
“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,” the testimony noted. “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.”
Bernanke said the October 2008 law that allows the Fed to pay interest on banks' holdings of reserve balances will allow the Fed to “put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks.”
Other tools have been created by the Fed to reduce reserves held by the banking system, in turn lowering the net supply of funds to the money markets, creating a tighter relationship between the interest rate on reserves and other short-term interest rates.
Reverse repurchase agreements, which the Fed has used to drain reserves from the banking system, are being expanded to include new counterparties. The Fed also plans “depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers,” to help drain reserves. These will be tested in the spring, the written testimony said.
“Reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so,” according to the text.
Another part of the exit strategy, Bernanke wrote, is “redeeming or selling securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Federal Reserve's balance sheet.”
But, he noted, “the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. 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. 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. If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate paid on reserves at about the same time it commences significant draining operations.”
Near-term, Bernanke said, he does not foresee the Fed selling any of its security holdings, “at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery. However, to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid.”
The Fed, he said, is now rolling over all maturing Treasury securities, but may not always roll them over in the future. “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,” the testimony noted. “Although passively redeeming agency debt and MBS as they mature or are prepaid will move us in that direction, the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted. Any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions.”
“As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets,” the text continued. “Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.”
