Posted on Wed, Feb. 10, 2010
last updated: March 15, 2013 11:58:21 AM
WASHINGTON — Federal Reserve Chairman Ben Bernanke Wednesday unveiled his strategy to mop up the massive credit stimulus that the Fed has provided the U.S. economy during the past two years.
The Fed's aggressive provision of credit helped to prevent a cataclysmic economic meltdown. It purchased complex bonds backed by car loans, student loans, mortgages and commercial loans, and extended huge amounts of short-term credit to keep financial markets from freezing.
Next, however, the Fed must unwind those massive holdings so they don't overheat the recovering economy and fuel inflation. Bernanke outlined his exit strategy in written testimony prepared for the House of Representatives Financial Services Committee. Washington's second major snowstorm in less than a week forced the cancellation of the panel's scheduled hearing, but the Fed chief released his plan to shrink the Fed's balance sheet, which has swelled above $2 trillion.
"The economy continues to require the support of accommodative monetary policies. However, we have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus," Bernanke wrote. "We have full confidence that, when the time comes, we will be ready to do so."
The key phrase there is "when the time comes."
Bernanke signaled that he thinks that time is still a long way off. Even so, he announced changes to the Fed's discount window operation, where banks can borrow on an emergency basis at a premium. Bernanke said discount loans are now 28-day loans, no longer for 90 days. The maximum loan amounts will soon be lowered, as well, he said, and the cost of borrowing emergency money will soon go up, too.
"These changes . . . should be viewed as further normalization of the Federal Reserve's lending facilities, in light of the improving conditions in financial markets," forecaster RDQ Economics in New York said in a research note.
Big Wall Street investors and foreign buyers of U.S. debt, such as China and Japan, have demanded that the Fed explain how plans to unwind its massive stimulus without sparking inflation that would erode the value of their assets and the purchasing power of ordinary Americans.
The biggest Fed change that will affect consumers is a switch in the benchmark the Fed uses to determine short-term U.S. lending rates.
For decades, the Fed has set a target for the federal funds rate — what banks charge each other for overnight loans. That, in turn, influences the prime rate, which banks extend to their most creditworthy borrowers and is a reference point for all sorts of other lending.
Since December 2008, the fed funds rate has effectively been zero, and the Fed recently began paying banks 0.25 percent interest on their cash that exceeds the reserves required by regulation and is parked at the Fed's district banks.
When the economy revives and it becomes necessary to raise interest rates to contain inflation, the Fed will do so using a new mechanism — the interest rate it pays banks on these excess reserves. Because so much money is now parked on the sidelines, Fed officials think this will be a better way to influence the rates banks charge consumers and businesses.
As before, the Fed will raise the cost of borrowing to slow economic activity, but now it will do so by paying interest on excess cash to discourage banks from lending. The European Central Bank already has made this shift.
"What you worry about is we have a lot of reserves in the banking system. Ultimately they'll get used and create a multiplier expansion in the money supply," said Vincent Reinhart, a former chief economist at the Fed's rate-setting Open Market Committee.
A jump in the money supply would impede the Fed's ability to contain inflation.
"Paying interest on banks is a way to induce idle balances, shortcut the multiplier effect," said Reinhart, now a researcher at the American Enterprise Institute, a conservative policy organization. "Bank behavior is going to be different, the Fed can't necessarily rely on its old rules of thumb."
Bernanke could face criticism for this policy change. If the Fed seeks to shrink its balance sheet quickly, Bernanke could be blamed for taking losses. If the Fed's balance sheet stays large, critics may see this policy change as a subsidy in the payment of high interest rates to banks.
"That's going to be a problem as they tighten policy," Reinhart said. "It's going to be very tough to sit before a panel on Capitol Hill and answer the question of what happened to your profits and why are you subsidizing big banks, even as the unemployment rate remains high."
The Fed reported a record profit in 2009 of more than $45 billion because of the massive holdings it has acquired. Whether these ultimately prove to be profit or loss depends on the conditions under which the Fed eventually sells them off.
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