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As Fed unravels crisis interventions, success may depend on untested strategies

By Neil Irwin
Washington Post Staff Writer
Thursday, February 11, 2010; A19

For those who worry that the Federal Reserve won't be able to unwind its elaborate efforts to support the economy in time to prevent a burst of inflation, Chairman Ben S. Bernanke had a message Wednesday: We've got this covered.

In written testimony to Congress, Bernanke gave the most detailed accounting to date of how the Fed plans to sop up the vast amount of money it injected into the financial system during the economic crisis.

But even as he laid out the "how" of the Fed's exit strategy, Bernanke was vague on the "when." Indeed, if financial markets are confident that the Fed has the right tools to unwind that economic support, it will give him greater flexibility on the timing.

With the economy still weak and the inflation threat appearing distant, any increase in interest rates is at least several months away, an idea Bernanke repeated by affirming that rates are likely to remain "exceptionally low" for "an extended period."

"We have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus," said Bernanke, whose Wednesday appearance before the House Financial Services Committee was canceled because of snow. (The Fed released his testimony anyway.) "We have full confidence that, when the time comes, we will be ready to do so."

After the onset of the financial crisis in August 2007 and a recession that began in December 2007, the Fed undertook a wide range of policies to prop up the financial system and the economy. They included a target interest rate that has been near zero for the past 14 months and the injection of nearly $1.5 trillion into the economy through purchases of mortgage-related securities.

But after the Great Intervention, the Bernanke Fed is now contemplating the Great Unwind, trying to figure out how to suck that money out of the economy in a way that neither stops the nascent recovery in its tracks nor leaves so much money flowing through the economy as to cause high inflation.

The Fed's new power

The Fed's strategy hinges on a major shift in its monetary policymaking. For decades, the central bank has used the federal funds rate as its primary tool for controlling the money supply. Under the approach outlined by Bernanke, the Fed would take advantage of a relatively new power to pay interest on the funds that banks keep on reserve with the central bank.

In effect, if banks increase their lending so much that too much money starts swirling through the economy, raising the risk of inflation, the Fed can increase the interest rate that banks receive to keep money locked up at the central bank above its current 0.25 percent. That would slow bank lending, keep the supply of money in check and, Bernanke argued, lead to higher interest rates for all sorts of loans.

"By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates," which would be reflected in long-term interest rates and financial conditions, he said.

Bernanke explicitly mentioned the possibility that anyone who wants to understand how loose or restrictive the central bank is being in the near future should watch that alternative interest rate. "It is possible that the Federal Reserve could for a time use the interest rate paid on reserves," in combination with other factors, "as a guide to its policy stance."

The move is uncharted territory for the Fed, which gained the power to pay interest on bank reserves only in October 2008. Even central bank insiders are unsure whether it will work.

That uncertainty is one reason the Fed is also developing other tools to drain cash out of the financial system. While raising the interest rate on reserves may be the Fed's core tool, Bernanke suggested that it might first try some less conventional ways to drain liquidity from the system.

Other strategies

Among the possibilities are novel tools known as reverse repurchase agreements, through which the Fed sells securities with an agreement to buy them back at a later date, effectively sucking money out of the financial system for that span. A second approach would be "term deposits," in which the Fed would offer banks a higher interest rate on reserves if they deposit them for some fixed period of time, the equivalent of certificates of deposit.

The New York Fed is running tests of those strategies this spring, Bernanke said, and Fed watchers think that those tools could ultimately be used to drain hundreds of billions of dollars from the financial system.

"They have their work cut out for them," said Ray Stone, managing director of Stone & McCarthy Research Associates. "Ben Bernanke articulated the plan pretty well today, but there's going to be a bit of experimentation here."

Another option for reducing the money supply, which some Fed officials advocate but Bernanke played down, would be simply to sell some of the assets now on the Fed's $2.2 trillion balance sheet, thereby reducing the amount of money. But that could have a particularly damaging effect on the economy; for example, sales of mortgage-backed securities would probably drive up mortgage rates and damage the already weak housing sector.

While serious efforts to reduce the money supply appear to be quite some time away, another part of the Fed's exit strategy could be imminent.

During the financial crisis, the Fed reduced the premium that banks must pay to take out emergency loans at the Fed, known as the discount window, from 1 percent to 0.25 percent. The Fed will "before long" widen that spread, effectively raising the rate banks pay for emergency loans but not increasing interest rates more broadly through the economy.

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