WASHINGTON — With the economy showing signs of recovery, Federal Reserve Board Chairman Ben Bernanke gave more clues Wednesday to how the central bank will return to normal and made clear that financial institutions are central to his plans.
One of the biggest challenges facing the Fed is figuring out how to grapple with the trillions in cash it has dumped into financial markets since 2007 to fight the financial crisis. If the Fed is to avoid inflation, it must find a way to sop up that cash. Given how much is out there, Bernanke said, the central bank's traditional tool — raising the federal funds rate — may not be enough.
"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," he said in written testimony that was to have been delivered to a House Financial Services Committee hearing Wednesday before a snowstorm canceled it.
Bernanke is turning to the rate the Fed pays for reserves that financial institutions deposit in the central bank — currently 0.25% — as an "alternative short-term interest rate."
"It is possible that the Federal Reserve could for a time use the interest paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance," Bernanke said.
Congress gave the Fed authority to pay interest on reserves in October 2008, and banks had $1.1 trillion on deposit in the central bank on Feb. 3. Raising the rate the Fed pays on reserves would encourage banks to park more of their money with the central bank, achieving Bernanke's goal of taking money out of the marketplace.
Bernanke is unlikely to raise rates on reserves soon, but when he does, observers said, the increase must be decisive.
"They will have to be very careful what interest they pay," said Rajeev Dhawan, the director of the Economic Forecasting Center at Georgia State University's J. Mack Robinson College of Business. "If they put the rate below market rates, why would banks leave their money there? They will have to be very aggressive in raising the rates if the economy recovers fast."
Paying higher interest on reserves could effectively draw money to the Fed that would otherwise have gone into loans. And this could set the Fed on a collision course with other agencies of the government. The Obama administration has consistently chided the banking industry for not making enough loans and has directed $30 billion from the Troubled Asset Relief Program to community banks to stimulate small-business lending.
"This is the $64,000 question," Dhawan said. Can Fed officials "insulate themselves from the political pressure?"
But others played down the potential for a clash, especially because the Fed has made it clear it will not clamp down on credit anytime soon. "There's no indication he's getting anywhere near tightening," said Chris Low, the chief economist at First Horizon National Corp.'s FTN Financial.
After its policymaking meeting last month, the Fed said low rates would persist for an "extended period." The fed funds rate has been held between 0% and 0.25% since late 2008.
In his prepared testimony, Bernanke highlighted two other tools the Fed is preparing to use to remove liquidity from the financial markets.
The first is reverse repurchase agreements it will execute with a wider group of counterparties than the primary dealers typically relied on by the Federal Reserve Bank of New York.
"In a reverse repo, the Federal Reserve sells a security to a counterparty with an agreement to repurchase the security at some date in the future," Bernanke said. "The counterparty's payment to the Federal Reserve has the effect of draining an equal quantity from the banking system."
The New York Fed began selling securities in December as a way to test the repo market. Bernanke said in his prepared testimony that the Fed has "enhanced its abilities to use reverse repos to absorb very large quantities of reserves."
A second tool the Fed is developing involves term deposits, a sort of certificate of deposit for banks.
Bank depositors would get a separate account at the Fed that would earn interest and mature within a year. Like the other proposals, these accounts would help shift money out of the financial system.
Bernanke said he hopes to do "test transactions" for term deposits in the spring.
"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," he said.
With so many levers to pull, confusion has arisen about which the Fed would try first. Bernanke said the nature of the Fed's exit from financial markets "will depend on economic and financial developments," but he said the first step is for the Fed to continue testing its tools.
"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," he said. "The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves."
Less clear is how the Fed will manage the $175 billion in debt and $1.25 trillion in mortgage-backed securities it expects to have purchased from the government-sponsored enterprises by the end of March. If the Fed expects to sell these securities, there is concern that private investors may stay out of those markets for fear of being diluted.
Bernanke said he has no plan to sell securities in the "near term," and he noted that the debt and mortgage-backed securities are being allowed to mature and run off the Fed's balance sheet. Still, he said, the Fed could begin selling the securities "when the economic recovery is sufficiently advanced." Any sales "would be at a gradual pace, would be clearly communicated to market participants and would entail appropriate consideration of economic conditions."