Posted on 21 Jul 2009
U.S. Federal Reserve Chairman Ben Bernanke shed light Tuesday on the toolkit the central bank can employ to unwind its crisis measures, but made clear to lawmakers that the economy remains too weak to start tightening monetary policy.
Mr. Bernanke reiterated that despite recent improvements in the economy and financial markets, the federal funds rate will likely remain near zero for an extended period of time. But he also laid out a number of other steps the Fed can take to tighten policy as needed to head off a potential buildup in inflation.
"In light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery," Mr. Bernanke said in prepared remarks to the House Financial Services Committee.
"However, we also believe that it is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation," he said.
Some of the emergency measures put in place during the crisis have already started to wind down, and Mr. Bernanke said that process should continue to some extent since the liquidity facilities are priced at a premium over normal spreads. The total amount of credit the Fed has extended to banks and other firms has fallen below $600 million from about $1.5 trillion at the end of 2008, he said.
"Nevertheless, should economic conditions warrant a tightening of monetary policy before this process of unwinding is complete, we have a number of tools that will enable us to raise market interest rates as needed," the Fed chief said in the first of two days of testimony on Capitol Hill in a twice-yearly ritual.
As first detailed in an editorial he penned Tuesday in The Wall Street Journal, Mr. Bernanke laid out a number of measures that could make up part of the central bank's eventual exit strategy.
The main tool is the Fed's ability, granted by Congress last fall, to pay interest rates on the balances held at the central bank by depository institutions. Paying more on those reserves would likely push up market rates, as well, he said.
In addition, the Fed could drain liquidity from the system through reverse repurchase agreements, selling securities from the central bank's portfolio with an agreement to buy them back later, said Mr. Bernanke. If necessary, the central bank could also sell its holdings of long-term maturities outright.
"In sum, we are confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability," he said.
The Fed has been actively buying securities as part of its plan to contain interest rates and support the mortgage market, with plans to purchase up to $300 billion in longer-term Treasury securities and $1.45 trillion of mortgage-linked securities. While there had been speculation that the central bank could expand that program, minutes from the June 23-24 meeting of the Federal Open Market Committee showed concern that any increases may be ineffective and even backfire if they are seen by the public as an attempt to help the government fund the growing budget deficit.
While Bernanke gave a more upbeat assessment of the economy and markets, he noted that the financial system remains stressed and the labor market has continued to weaken.
The pace of economic decline "appears to have slowed significantly," he said, while citing "notable improvements" in financial conditions.
The economic outlook was included in a monetary policy report the Fed submitted to Congress Tuesday along with Mr. Bernanke's testimony. The revised forecasts, predicting a contraction of between 1.0% and 1.5% this year followed by a 2.1% to 3.3% rebound in 2010, was first released last week within the minutes of the June policy meeting.
Mr. Bernanke expressed concern about the prospect of a jobless recovery, however. The unemployment rate is already at a 26-year high of 9.5%, and the Fed expects it to end the year between 9.8% and 10.1%.
"Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending," said Mr. Bernanke, warning that the recent stabilization in consumer spending may not hold.
Meanwhile, he urged lawmakers to start work on unwinding their own efforts to combat the recession through fiscal stimulus, saying the planning needs to be started now on returning to a balanced budget.
"Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth," said Mr. Bernanke.
Addressing a topic that will likely be heavily debated during the two days of testimony, the future role of the Fed, Mr. Bernanke said the central bank will continue to strengthen supervision and improve the resiliency of the financial system.
The Obama administration has proposed promoting the central bank to the role of systemic risk regulator, while placing its powers to regulate consumer products into a new consumer protection agency.
Fed officials have pushed back against losing their consumer protection powers, and Mr. Bernanke reiterated the central bank wants to work with lawmakers to try to "further formalize" that role.
In addition, he warned that pending legislation to subject the Fed to greater oversight by the Government Accountability Office could jeopardize the central bank's independence if it extends to monetary policy.
"A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability," he said.