Bernanke Explains How He Will Stem Money Tide

To keep the U.S. economy's pulse rate up in 2008 as the recession deepened, Federal Reserve Chairman Ben Bernanke used various means to pump the economy's life blood, money into the system.

He was scheduled to be on Capitol Hill Wednesday to explain to a House committee how he planned to reabsorb all the cash he put into the system. But the Blizzard of 2010 made that impossible.

But the Federal Reserve made Bernanke's prepared remarks available. In them, Bernanke explains that one of the ways the central bank plans to pull money out of the system as economic conditions improve further is to raise interest rates but not necessarily the federal-funds rate it has raised in the past.

Instead of raising the federal-funds rate — the rates banks charge each other for overnight loans — the Fed would instead raise the rate on what it pays banks that leave money on deposit with the central bank.

That would likely force many banks to generally to raise their rates in order to compete with the Fed as a place to deposit money and would have the net effect of tightening up the money supply.

As Bernanke's testimony explains:

Most importantly, in October 2008 the Congress gave the Federal Reserve statutory authority to pay interest on banks' holdings of reserve balances. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.

Another way the Fed might absorb some of the massive cash infusion it put into the system, Bernanke said, could by giving banks a new deposit product at the Fed where they could park money.

 

As a second means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers. The Federal Reserve would likely auction large blocks of such deposits, thus converting a portion of depository institutions' reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves. A proposal describing a term deposit facility was recently published in the Federal Register, and we are currently analyzing the public comments that have been received. After a revised proposal is reviewed by the Board, we expect to be able to conduct test transactions this spring and to have the facility available if necessary shortly thereafter. 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.

Bernanke sent an important signal about the declining significance of the federal-funds rate, the key rate nearly everyone pays attention to when the Fed meets in order to see if interest rates will trend higher or lower.

Because there so much money coursing through the economy, the federal-funds rate is probably not the best indicator currently of the condition of the short-term lending markets.

So the Fed may soon point all of us to other indicators which it may use as guidance on whether to try and tighten or loosen the money supply.

More Bernanke:

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 of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn.