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By BEN BERNANKE
The depth and breadth of the global recession has required a highly
accommodative
monetary policy. Since the onset of the financial crisis
nearly two years ago, the Federal Reserve has reduced the
interest-rate
target for overnight lending between banks (the
federal-funds rate) nearly to zero. We have also greatly expanded the
size
of the Fed’s balance sheet through purchases of longer-term
securities and through targeted lending programs aimed
at restarting
the flow of credit.
These actions have softened the economic impact of the financial
crisis. They
have also improved the functioning of key credit markets,
including the markets for interbank lending, commercial paper,
consumer
and small-business credit, and residential mortgages.
My colleagues and I believe that accommodative policies will
likely be
warranted for an extended period. At some point, however, as economic
recovery takes hold, we will need to
tighten monetary policy to
prevent the emergence of an inflation problem down the road. The
Federal Open Market Committee,
which is responsible for setting U.S.
monetary policy, has devoted considerable time to issues relating to
an exit strategy.
We are confident we have the necessary tools to
withdraw policy accommodation, when that becomes appropriate, in a
smooth
and timely manner.
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Chad Crowe
The exit strategy is closely tied to the management of the
Federal
Reserve balance sheet. When the Fed makes loans or acquires
securities, the funds enter the banking system and
ultimately appear
in the reserve accounts held at the Fed by banks and other depository
institutions. These reserve
balances now total about $800 billion,
much more than normal. And given the current economic conditions,
banks have
generally held their reserves as balances at the Fed.
But as the economy recovers, banks should find more opportunities
to
lend out their reserves. That would produce faster growth in broad
money (for example, M1 or M2) and easier credit
conditions, which
could ultimately result in inflationary pressures—unless we adopt
countervailing policy measures.
When the time comes to tighten
monetary policy, we must either eliminate these large reserve balances
or, if they remain,
neutralize any potential undesired effects on the
economy.
To some extent, reserves held by banks at the Fed will
contract
automatically, as improving financial conditions lead to reduced use
of our short-term lending facilities,
and ultimately to their wind
down. Indeed, short-term credit extended by the Fed to financial
institutions and other
market participants has already fallen to less
than $600 billion as of mid-July from about $1.5 trillion at the end
of
2008. In addition, reserves could be reduced by about $100 billion
to $200 billion each year over the next few years as
securities held
by the Fed mature or are prepaid. However, reserves likely would
remain quite high for several years
unless additional policies are
undertaken.
Even if our balance sheet stays large for a while, we have two broad
means
of tightening monetary policy at the appropriate time: paying
interest on reserve balances and taking various actions that
reduce
the stock of reserves. We could use either of these approaches alone;
however, to ensure effectiveness, we likely
would use both in
combination.
Congress granted us authority last fall to pay interest on balances
held by banks
at the Fed. Currently, we pay banks an interest rate of
0.25%. When the time comes to tighten policy, we can raise the
rate
paid on reserve balances as we increase our target for the federal
funds rate.
Banks generally will not
lend funds in the money market at an interest
rate lower than the rate they can earn risk-free at the Federal
Reserve.
Moreover, they should compete to borrow any funds that are
offered in private markets at rates below the interest rate
on reserve
balances because, by so doing, they can earn a spread without risk.
Thus the interest rate that the Fed
pays should tend to put a floor
under short-term market rates, including our policy target, the
federal-funds rate.
Raising the rate paid on reserve balances also
discourages excessive growth in money or credit, because banks will
not
want to lend out their reserves at rates below what they can earn
at the Fed.
Considerable international experience
suggests that paying interest on
reserves effectively manages short-term market rates. For example, the
European Central
Bank allows banks to place excess reserves in an
interest-paying deposit facility. Even as that central bank’s
liquidity-operations
substantially increased its balance sheet, the
overnight interbank rate remained at or above its deposit rate. In
addition,
the Bank of Japan and the Bank of Canada have also used
their ability to pay interest on reserves to maintain a floor under
short-term
market rates.
Despite this logic and experience, the federal-funds rate has dipped
somewhat below the rate paid
by the Fed, especially in October and
November 2008, when the Fed first began to pay interest on reserves.
This pattern
partly reflected temporary factors, such as banks’
inexperience with the new system.
However, this pattern
appears also to have resulted from the fact that
some large lenders in the federal-funds market, notably
government-sponsored
enterprises such as Fannie Mae and Freddie Mac,
are ineligible to receive interest on balances held at the Fed, and
thus
they have an incentive to lend in that market at rates below what
the Fed pays banks.
Under more normal financial
conditions, the willingness of banks to
engage in the simple arbitrage noted above will tend to limit the gap
between
the federal-funds rate and the rate the Fed pays on reserves.
If that gap persists, the problem can be addressed by supplementing
payment
of interest on reserves with steps to reduce reserves and
drain excess liquidity from markets—the second means of
tightening
monetary policy. Here are four options for doing this.
First, the Federal Reserve could drain bank reserves
and reduce the
excess liquidity at other institutions by arranging large-scale
reverse repurchase agreements with financial
market participants,
including banks, government-sponsored enterprises and other
institutions. Reverse repurchase agreements
involve the sale by the
Fed of securities from its portfolio with an agreement to buy the
securities back at a slightly
higher price at a later date.
Second, the Treasury could sell bills and deposit the proceeds with
the Federal Reserve.
When purchasers pay for the securities, the
Treasury’s account at the Federal Reserve rises and reserve balances
decline.
The
Treasury has been conducting such operations since last fall under
its Supplementary Financing Program. Although the Treasury’s
operations
are helpful, to protect the independence of monetary
policy, we must take care to ensure that we can achieve our policy
objectives
without reliance on the Treasury.
Third, using the authority Congress gave us to pay interest on banks’
balances
at the Fed, we can offer term deposits to banks—analogous to
the certificates of deposit that banks offer their customers.
Bank
funds held in term deposits at the Fed would not be available for the
federal funds market.
Fourth, if necessary,
the Fed could reduce reserves by selling a
portion of its holdings of long-term securities into the open market.
Each
of these policies would help to raise short-term interest rates
and limit the growth of broad measures of money and credit,
thereby
tightening monetary policy.
Overall, the Federal Reserve has many effective tools to tighten
monetary
policy when the economic outlook requires us to do so. As my
colleagues and I have stated, however, economic conditions
are not
likely to warrant tighter monetary policy for an extended period. We
will calibrate the timing and pace of any
future tightening, together
with the mix of tools to best foster our dual objectives of maximum
employment and price
stability.
—Mr. Bernanke is chairman of the Federal Reserve.
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