Yesterday, the House Committee on Financial Services was scheduled to hold a hearing titled: “Unwinding Emergency Federal Reserve Liquidity Programs and Implications for Economic Recovery.” The hearing was postponed due to inclement weather. However, because of the nature of the hearing, and the importance of the subject matter to the economy, the Committee released Chairman Bernanke’s statement and the statements of the other witnesses.
- Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System
- Marvin Goodfriend, Professor of Economics and Chairman of the Gailliot Center for Public Policy, Tepper School of Business, Carnegie Mellon University
- Jan Eberly, John L. and Helen Kellogg Professor of Finance, Kellogg School of Management, Northwestern University
- Richard C. Koo, Chief Economist, Nomura Research Institute
- Laurence Ball, Professor of Economics, Johns Hopkins University
- John B. Taylor, Mary and Robert Raymond Professor of Economics, Stanford University
In his statement, Chairman Bernanke outlines the Federal Reserve’s strategy for unwinding the lending and monetary policies that have been put in place to stabilize the credit markets and returning to pre-crisis policies regarding liquidity programs and monetary policy and asset purchase activities.” He discusses the winding down of emergency lending facilities; raising the discount rate; four key exit strategy tools the Federal Reserve could implement to speed draining of excess bank reserves and raise the federal fund rate; and temporarily replacing the federal funds rate as a tool for communicating monetary policy.
In discussing the Federal Reserve’s strategy for winding down the emergency lending facilities, Bernanke began by outlining the Federal Reserve’s efforts over the past 2½ years to ensure access to short-term credit for financial institutions as private sources of liquidity were drying up -- including the Term Auction Facility (TAF), temporary currency swap agreements with foreign central banks (to lend to primary dealers on an overnight, overcollateralized basis) and other key stabilizing facilities. He reported that, as of today, of the facilities that offer credit to multiple institutions, only TAF and the Term Asset-Backed Securities Loan Facility (TALF) are still in operation and these liquidity facilities are scheduled to be phased out in March and June. Bernanke also discussed the use of the Federal Reserve’s emergency lending powers to prevent the failures of AIG and Bear Stearns providing only that the Fed expects these exposures, which currently total almost 5 percent of the Federal Reserve’s balance sheet, to “decline gradually over time.”
Bernanke writes that the Federal Reserve expects a modest increase in the spread between the discount rate and the target federal funds rate. He did not say when the Federal Reserve expects to raise the discount rate, but said only that it should happen “before long.” Bernanke also discussed the Federal Reserve’s efforts to normalize the terms of the regular discount window loans, noting that the maximum maturity window has already been reduced form from 90 days to 28 days and that “[t]hese changes, like the closure of a number of lending facilities earlier this month, should be viewed as further normalization of the Federal Reserve’s lending facilities, in light of the improving conditions in financial markets....”
Monetary Policy and Asset Purchases
Here, Bernanke discusses the Federal Reserve’s strategy for returning to a pre-crisis monetary policy. First, he outlines the Federal Reserve’s efforts to counter the adverse effects of the financial crisis by reducing the target federal funds rate to nearly zero by 2008 and then providing additional stimulus through large-scale purchases of federal agency debt and mortgage-backed securities. While surmising that these efforts have helped improve private credit market conditions and have caused longer-term private borrowing rates and spreads to drop, Bernanke notes that the asset purchases also left U.S. banks holding more than $1.1 trillion of reserves with Federal Reserve banks. Noting that continuing economic pressures will likely keep the federal funds rate at “exceptionally low levels ... for an extended period,” Bernanke suggested other means of tightening monetary conditions to ease concerns of inflationary pressures. Bernanke outlined four tools that the Federal Reserve could use to enable it to return to pre-crisis monetary policies at the appropriate time:
- The Federal Reserve could raise the federal funds rate by increasing the interest rate paid on banks’ holdings of reserve balances. Such an increase would cause short-term interest to rise as banks would be unwilling to supply short-term funds to the money market for rates lower than they could earn by holding reserves at the Federal Reserve Banks.
- The Federal Reserve could reduce the aggregate reserves in the banking system by arranging reverse repurchase agreements. The payments to the Federal Reserve for the securities would have the effect of draining an equal amount of reserves from the banking system.
- The Federal Reserve could lower the high level of bank reserves by offering term deposits to depository institutions. By auctioning large blocks of these securities, the Federal Reserve could convert a portion of the banks’ reserve balances into deposits that could not be used to meet short-term liquidity needs and thus could not be counted as reserves.
- Finally, the Federal Reserve could redeem or sell securities. A reduction in securities would reduce the quantity of reserves in the banking system and, as an added benefit, would reduce the overall size of the Federal Reserve’s balance sheet.
Bernanke states that the tools the Federal Reserve uses to exit the currently accommodative policy stance will depend on developments in the economic condition. He does not anticipate that the Federal Reserve will sell any security holdings in the near future at least until economic conditions are clearly improved. He explains, however, that the Federal Reserve is currently rolling over all maturing Treasury securities and allowing any securities the Federal Reserve owns, that mature or that are prepaid, to run off.
Finally, due to the impact of the high volume of bank reserves, Bernanke suggests that the federal funds rate could become an unreliable indicator of conditions in short-term money markets. Thus, he writes, the Federal Reserve is considering temporarily replacing the federal funds rate with an alternative tool for communicating the Federal Reserve’s monetary policies, such as the interest rate paid on reserves.