Business news

WASHINGTON — Federal Reserve Chairman Ben Bernanke on Wednesday unveiled his strategy to mop up the massive credit stimulus that the Fed has provided the U.S. economy during the last two years. But when this will happen remains in question.

The Fed’s aggressive provision of credit helped to prevent a cataclysmic economic meltdown. It purchased complex bonds backed by car loans, student loans, mortgages and commercial loans, and extended huge amounts of short-term credit to keep financial markets from freezing.

Next the Fed must unwind those massive holdings so they don’t overheat the recovering economy and fuel inflation. But at the same time, the Fed must shrink its balance sheet, which has swelled above $2 trillion, in a way that won’t cause the economy to stall.

Bernanke outlined his exit strategy in written testimony prepared for the House of Representatives Financial Services Committee. Washington’s second major snowstorm in less than a week forced the cancellation of the panel’s scheduled hearing.

"The economy continues to require the support of accommodative monetary policies. However, 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," Bernanke wrote. "We have full confidence that, when the time comes, we will be ready to do so."

The key phrase there is "when the time comes." Bernanke has signaled that he thinks that time is still a long way off, but big Wall Street investors and foreign buyers of U.S. debt, such as China and Japan, are demanding that the Fed explain how it plans to unwind its massive stimulus programs.

Investors fear that if the Fed doesn’t act, inflation could kick in, which would erode their assets and the purchasing power of ordinary Americans.

"What you worry about is we have a lot of reserves in the banking system. Ultimately they’ll get used and create a multiplier expansion in the money supply," said Vincent Reinhart, a former chief economist at the Fed’s rate-setting Open Market Committee.

Traditionally, the Fed controls economic growth through interest rates. If the economy starts to lag, the Fed can provide a boost by lowering the federal funds rate — what banks charge each other for overnight loans payday loans in 1 hour. That, in turn, influences the prime rate, which banks extend to their most creditworthy borrowers and is a reference point for all sorts of other lending. To slow economic growth, the Fed raises the federal funds rate.

But because the recession was so severe, the Fed took extraordinary actions, pumping billions of dollars into the economy by buying up bonds and even Treasury notes. In addition, the Fed issued low interest loans to banks to encourage more lending to businesses and consumers.

Now, as the economy stabilizes, the Fed must look for ways to soak up this excess. One way Bernanke said the Fed planned to do this is to raise the interest rate it will offer commercial banks to leave reserve funds parked in the Fed’s district banks.

"Paying interest on banks is a way to induce idle balances, shortcut the multiplier effect," said Reinhart, now a researcher at the American Enterprise Institute, a conservative policy organization.

The advantage of steering interest rates through the excess reserves rate gives the Fed more control over money floating around the financial system. The Fed sets that rate directly, while its federal funds rate is just a target. But a higher rate on banks’ excess reserves also would make it harder to borrow. Banks will be tempted to keep more money at the central bank, rather than lend it to individuals and businesses. But if the Fed tightens the credit market too aggressively, it could cause the economy to stall.

Bernanke on Wednesday, however, repeated the Fed’s pledge to hold interest rates at record lows for an "extended period." Economists think that means for at least six more months.

"The Fed is trying to show Wall Street and Congress ‘We’ve done our homework, and we have a strategy for getting back to normal,’" said Brian Bethune, economist at IHS Global Insight. "This is all designed to build confidence in the Fed’s exit strategy."

The Associated Press contributed to this report.

Source