Tuesday, February 16, 2010

Snowstorms fail to blow away Fed chief's exit strategy

Business Times - 16 Feb 2010

PERSPECTIVE
Snowstorms fail to blow away Fed chief's exit strategy

There are some novel tools in Bernanke's plan. But how effective will they be? By Leon Hadar

US FEDERAL Reserve chairman Ben Bernanke is considered to be one of the world's most powerful public figures. But not even he could overcome the might of Mother Nature that took the form of what has been described by pundits as a 'historic' snowstorm or the 'Snowcalypse', as Washingtonians refer to the mess that hit the US capital last week.

Indeed, not even the head of the US central bank was spared from the Washington area's unprecedented winter weather last week with the House of Representative's Financial Services Committee being forced to cancel Mr Bernanke's much-anticipated testimony which was scheduled for Wednesday.

He was expected to detail the way he was planning to unwind the Fed's liquidity programmes - trillions of US dollars of aid that have been given to American financial institutions in the aftermath of the meltdown - and the implications of that complex process for economic recovery. Ending the rescue measures too soon could retard the recovery, while waiting too long could ignite inflation.

But Mr Bernanke, who is trying to strike the right balance, did not leave Congress out in the cold and was still able to get his message across to lawmakers on Capitol Hill and to investors in Wall Street by releasing his prepared remarks to the media.

Interest rates

And while lawmakers will still have many opportunities (weather permitting) to grill the Fed chairman during other hearings this month, it is safe to say that his comments have not produced either a political blizzard or a financial storm after he had made it clear that the Fed was not going to raise the federal funds rate - the rates banks charge each other for overnight loans - anytime soon as opposed to 'at some point'.

'Although at present the US economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding,' Mr Bernanke wrote. 'We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively,' he stated.

Indeed, there was no dramatic news in Mr Bernanke's prepared remarks. He may have disappointed investors by not specifying a timeframe for reining in the rescue efforts.

The Fed chairman stressed that the central bank would keep the federal funds rate at its record low level for 'an extended period' and reiterated that the Fed expected conditions to warrant exceptionally low levels of the fed funds rate for an extended period and that 'before long' the Fed would consider 'a modest increase' in the spread between the fed funds rate and the discount rate.

At the same time, Mr Bernanke seemed to be providing a few new details about the options available to him and his colleagues to tighten credit. Hence, the Fed could encourage banks to store their money at the Fed by increasing the current 0.25 per cent level in interest rate paid to banks that do that, putting 'significant upward pressure on all short-term interest rates'.

Indeed, such a move could force many banks to raise their rates in order to compete with the Fed as a place to deposit money and would bring about tightening up the money supply - which is the main component of the Fed's exit strategy.

And the central bank could try to absorb more reserves from the banking system by using other tools in its disposal, including through so called 'reverse repurchase agreements' and by offering term deposits to banks.

In a reverse repurchase, the Fed agrees to sell securities such as Treasury bonds to investors for a short period and then buy them back at a slightly higher rate at a later date, allowing it to remove some money out of circulation for a time. Term deposits would give banks the incentive to leave money at the Fed for longer periods, probably ranging from one to six months.

Eventually, the Fed will also have to unwind over a trillion dollars worth of mortgage-backed assets. But Mr Bernanke indicated that selling these securities would not happen until 'the economy is clearly in a sustainable recovery'.

Assurances

In any case, Mr Bernanke's statement seemed to be offering assurances to lawmakers and investors that the central bank has a coherent exit strategy ready in place and that at some point it intends to start tapping on the financial brakes and to begin trimming its excess reserves and restore the Fed's ability to do its traditional job of managing the funds rate.

Some of the ideas for dealing with excess liquidity are novel tools in the Fed's kit. It remains to be seen if they will be used and if they will work as Mr Bernanke expects they will.

btworld@sph.com.sg



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