Fed to Reveal Its Strategy for Raising Interest Rates
Fed to Reveal Its Strategy for Raising Interest Rates
By Sewell Chan
The New York Times
Published: February 9, 2010
WASHINGTON - Ben S. Bernanke,
having survived a surprising challenge to his second term as Federal
Reserve chairman, now faces the delicate task of beginning to
pull the central bank out of its extraordinary effort to prop up
the economy.
The main question is when and how the Fed should start raising
short-term interest rates, which have been at a record low for more
than a year. Related is the issue of how to manage, and eventually
shrink, the record $2.2 trillion balance sheet that the Fed amassed
as it pumped vast sums of money into the economy, starting in 2008.
On Wednesday morning, the Fed will release a statement outlining
Mr. Bernanke's views on moving away from its exceptionally easy
monetary policy.
As a policy tool, Mr. Bernanke is expected to consider a
little-known mechanism - referred to as the interest rate on excess
reserves - that gives the Fed leverage over $1.1 trillion in bank
deposits.
Most of those deposits were created as the Fed gobbled up
mortgage-backed securities and Treasury
notes and bonds during the financial
crisis. The banks in turn parked the funds at the Fed as
reserves. In the months and years ahead, the Fed wants to make sure
that banks do not reduce their reserves too quickly, because it
could create inflationary pressures as banks step up their
lending.
To achieve its goal, according to Fed officials and speeches,
the central bank will raise the interest rate on excess reserves,
now 0.25 percent. It also plans to lift its target for the fed
funds rate - what banks charge one another for overnight loans and
the centerpiece of its policy statements since 1994. But officials
stress that rates will remain quite low for months to come.
"We're in a different situation than ever before, and the tools
we are using are entirely new," said Lyle E. Gramley, a former Fed
governor who now works at the Potomac Research Group, an investment
advisory firm.
Mr. Gramley predicted that Mr. Bernanke would try to reassure
the markets that the new tools would work. "There's an awful lot of
talk that we're going to have inflation down the road," he said.
"But this Fed is determined to maintain price stability. They've
said that over and over again, and they want to communicate that to
the markets."
Mr. Bernanke has used the term "exit strategy" to describe his
task. Much like the American military's withdrawal from Iraq, the
Fed's plan has few precedents and carries much uncertainty. At a
minimum, officials have signaled, it will have to be carried out
delicately, be flexible when circumstances change, and, most
likely, be gradual.
With unemployment at 9.7 percent, the Fed may be months away
from raising rates, but it is discussing the plan now to prepare
the markets and tamp down inflation fears, said Vincent R.
Reinhart, a former director of monetary affairs for the Fed.
"The reason they're starting to talk about the exit now is to
reassure investors, so that they aren't pressed to head for the
exit prematurely," said Mr. Reinhart, now a scholar at the
American Enterprise Institute. "Chairman Bernanke has to walk a
very, very fine line."
If the Fed raises interest rates too hastily, it could choke off
the fragile recovery. If it dallies, it might set off market
jitters about rising prices.
But that decision occurs in the context of an economy whose
normal rules have been reshaped. As Mr. Bernanke put it in a speech
last April, "we no longer live in a world in which central bank
policies are confined to adjusting the short-term interest
rate."
The Fed's balance sheet has nearly tripled since the summer of
2007. At the end of that year, the Fed found new ways to lend to
banks, and in early 2008, it began to cut interest rates
aggressively, pushing the target rate for fed funds to nearly zero
in December 2008.
By that month, the Fed's balance sheet had ballooned to $2.2
trillion as the central bank doled out loans to commercial banks,
issuers of commercial paper
and foreign central banks. The American
International Group, the bailed-out insurance giant, and JPMorgan
Chase, which bought Bear Stearns,
also received aid.
Many of those programs are winding down. Two of the biggest -
the Fed's purchase of $1.25 trillion of mortgage-backed securities
and of about $175 billion in debts guaranteed by
Fannie Mae, Freddie Mac and
Ginnie Mae - are to be completed by March 31.
The Fed in essence created new money to buy those securities,
and now holds $1.1 trillion in reserves that the banks can demand
when they wish. "The Fed's great worry is that instead of holding
onto these reserves, the banks would decide they'd rather take the
money they're tying up and lend it out," said Anil K. Kashyap, a
professor of economics and finance at the University of Chicago's
business school. If they did that, "you'd see broad measures of
money growing quickly, and presumably that would be the start to
having some inflation."
In the short term, that prospect seems remote, as banks have
been wary and tightfisted in lending since the financial crisis
erupted. But in the long run, a huge balance sheet carries
risks.
The ability to charge an interest rate on excess reserves was
created in 2006, after decades of discussion, when Congress granted
the Fed such authority. (One reason it took so long is that the
interest payments will reduce the amount the Fed turns over to the
Treasury
each year.) The tool - which is used by other central banks, like
those in England and Canada - was to become available in 2011, but
Congress moved up the date during the crisis. The Fed started
paying the interest in October 2008.
Mr. Bernanke has argued that the new rate will eventually serve
as an interest-rate floor, with the discount rate - the rate at
which the Fed lends directly to banks - functioning as the ceiling,
and the fed funds rate fluctuating in between them.
Looking longer term, Mr. Bernanke has four other tools that
could be used gingerly to tighten monetary policy. The first is
reverse repurchase agreements, or reverse repos, in which the Fed
would sell securities from its portfolio with an agreement to buy
them back at a slightly higher price at a later date. The second is
term deposits, analogous to the certificates of deposit banks offer
to customers. Third, the Treasury could sell bills and deposit the
proceeds at the Fed.
Finally, the Fed could sell some of its long-term securities,
including those backed by mortgages, taking more money out of the
system. That strategy would carry risk given that the Fed's
ownership of such securities is helping keep mortgage rates low and
support the housing market.
Mr. Bernanke's statement was initially to be presented at a
House hearing scheduled for Wednesday. After the hearing was
postponed because of snow, he decided to release it anyway.
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