Fed designed to induce banks to keep money there rather than lending it out
Bernanke May Hold Rates Down by Showing He Can Reverse Course
July 20, 2009 (Bloomberg) -- To keep interest rates at a record low, Ben S.
Bernanke may have to show Congress and investors he can be as creative about
soaking up cash from the financial system as he was when pouring it in.
The Federal Reserve chairman will probably outline his strategy for exiting the
biggest monetary expansion in history when he delivers his semiannual economic
report to Congress tomorrow. Among the options: establishing term deposits at
the Fed designed to induce banks to keep money there rather than lending it
out, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City,
New Jersey.
Laying out a plan now may give Bernanke leeway to hold down borrowing costs for
as long as it takes to reduce unemployment from a quarter-century high. To do
that, he first has to convince lawmakers and investors he’s ready and able to
contain inflation as the economy recovers.
“Bernanke needs to explain that the Fed has the tools to do the job and that it
intends to use them forcefully when it has to,” said Lyle Gramley, senior
economic adviser with New York-based Soleil Securities Corp. and a former
central bank governor. “That would help hold down inflation expectations and
give the Fed the opportunity to stay easier for longer.”
House Financial Services Committee Chairman Barney Frank said he expects
Bernanke to spell out how the Fed will end its unprecedented expansion of
credit when he testifies before the Massachusetts Democrat’s panel tomorrow.
‘Prepared to Unwind’
“I’ve urged him to be ready to tell people how he’s prepared to unwind some of
those facilities when it’s prudent to do so,” Frank said.
Bernanke is “very conscious” of worries that the Fed may end up rekindling
inflation, the lawmaker said.
Already, some investors are betting such concerns will force Bernanke’s hand.
Trading in federal-funds futures suggests a better-than-even chance the central
bank will raise its short- term interest-rate target by January from the
current range of zero to 0.25 percent.
Laurence Meyer, another former Fed governor who’s now vice chairman of St.
Louis-based Macroeconomic Advisers LLC, said policy makers will need to keep
rates unchanged a lot longer, perhaps until late 2011, to bring down
unemployment.
The Fed’s latest forecast, published July 15, projects the jobless rate will
rise to 9.8 percent to 10.1 percent next quarter, from 9.5 percent now, and
will still be 9.5 percent or higher at the end of 2010.
Fed’s Holdings
Bernanke’s purchases of assets such as mortgage bonds and Treasury securities
pumped money into the financial system in an effort to lift the economy out of
its deepest decline in half a century. That helped to more than double the
Fed’s holdings to a record $2.3 trillion in December from a year earlier. The
balance stood at $2.1 trillion last week.
Meanwhile, banks’ excess reserves at the Fed rose to a record $877.1 billion
daily average in the two weeks ended May 20, from $2 billion a year earlier.
Excess reserves -- money available for lending that banks choose to leave with
the Fed instead -- averaged $743.9 billion in the first two weeks of this
month.
While policy makers would like credit markets to recover, they don’t want banks
to lend that cash out all at once as the economy improves, because that could
unleash inflation, said William Poole, former president of the St. Louis Fed.
So the central bank is counting on its ability to pay interest on those
reserves to help keep a lid on prices.
“Interest on reserves is an important part of the exit strategy,” Fed Vice
Chairman Donald Kohn said at a conference at Princeton University May 23.
Not So Easy
Poole said it may not be so easy for the Fed to choke off credit expansion by
raising the rate paid on reserves once banks start lending in earnest.
“Historically, banks have had to fund new loans by adding to their liabilities,
by issuing certificates of deposit or commercial paper,” said Poole, a senior
economic adviser to Palo Alto, California-based Merk Investments LLC. This
time, they will be able to finance increased lending just by “drawing on an
asset they already are sitting on,” which is the reserves at the Fed.
A possible way to counteract that would be by establishing term deposits at the
central bank, where excess reserves could be parked for extended periods,
rather than just overnight, Crandall said. The Fed might hold periodic auctions
to encourage banks to leave the funds with it, he added.
U.S. central bankers have also mentioned using reverse repurchase agreements to
help drain money from the financial system. In such a transaction, the Fed
would sell bonds to Wall Street dealers with an agreement to buy them back
later.
Fed’s June Meeting
Fed staff briefed policy makers on ways to exert greater control over the
supply of reserves at their meeting on June 23- 24, according to the minutes.
“Meeting participants agreed that the Federal Reserve either had or could
develop tools to remove policy accommodation when appropriate,” the minutes
said.
There’s a risk Bernanke might end up fanning expectations of a Fed tightening
if he harps on the exit strategy, Crandall said. “If you’re a parent trying to
get your child to sleep, you don’t do that by assuring them there are no
monsters under the bed,” he said.
Mark Gertler, a co-author with Bernanke on economic research, said the Fed
chairman needs to stress that he’ll keep interest rates low for the foreseeable
future.
Strengthening Commitment
“It’s important for the Fed to be clear that it’s not going to exit prematurely
and to strengthen its commitment to stay accommodative,” said Gertler, a
professor of economics at New York University.
Complicating Bernanke’s task is what Tom Gallagher, head of policy research at
International Strategy and Investment Group in Washington, calls the Fed’s
“unsettled institutional backdrop.” The 55-year-old’s term as Fed chairman ends
in January, and President Barack Obama has yet to say whether he’ll nominate
Bernanke for another four-year run.
Lawmakers have stepped up their attacks on the Fed for pushing the limits of
its authority to avert a collapse of the financial system, committing $81
billion to stabilize insurer American International Group Inc. and helping push
through Bank of America Corp.’s purchase of Merrill Lynch & Co. last year.
Some legislators advocate congressional audits of the Fed’s money policy.
Others are considering subjecting the appointment of regional Fed presidents,
who vote on interest rates, to Senate approval.
Inflation Expectations
Investor expectations for inflation for 2015 to 2019 -- the so-called
five-year, five-year forward rate calculated by the Fed -- increased to 2.79
percent last week from 2.1 percent at the start of the year. The rate, which is
based on trading in Treasury Inflation Protected Securities, has averaged 2.66
percent since 2005.
What’s got investors concerned is the combination of the Fed’s expanded balance
sheet, a record $1.8 trillion budget deficit and the building congressional
pressure on the politically independent central bank, said Peter Hooper, chief
economist for Deutsche Bank Securities in New York.
“That raises the stakes and the potential for an inflationary misstep,” said
Hooper, a former Fed official. “It’s in the Fed’s interest to reassure
investors that won’t happen.”
