Bernanke Explains Options the Fed Has, Emphasizes the Need for Financial Stabilization

Bernanke's speech this morning was a brief summary of what the Fed has undertaken since the current crisis commenced in August 2007 and a description of the Fed's available policy options since it lowered the federal funds rate to a 0%-0.25% band on December 16. He did not reveal any new programs but presented a classification of the different non-interest rate related actions of the Fed and concluded with an exit strategy of the Fed. He also commented on fiscal policy actions that will be necessary to restore financial market stability and get the economy back on track.

Bernanke classifies the programs put in place under three heads. (1). The first group of tools involves lending directly to financial institutions, which is related to the Fed's role as lender of last resort. The Fed had to step in to provide liquidity to financial institutions as credit markets froze significantly during the course of the crisis. One of the methods the Fed employed was by lowering of the spread between the discount rate and federal funds, extending the term of the discount window to 90 days from the existing arrangement of overnight loans. The other programs are: The Term Auction Facility under which credit is auctioned for three months; the Term Securities Lending Facility, which enables primary dealers to borrow Treasury securities from the Fed with less-liquid collateral; and the Primary Dealer Credit Facility, an overnight loan facility for primary dealers in exchange for collateral. Bilateral currency swap arrangements with 14 central banks have addressed the global dollar liquidity problem. (2). The second set of policy tools provides liquidity directly to key credit markets through purchase of highly rated commercial paper for three months and backup liquidity for money market mutual funds. (3). The purchase of longer-term securities constitutes the third set of policy tools. The Fed plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in mortgage-backed securities. These programs have been instituted on different dates since August 2007. The programs have succeeded in bringing down financial market spreads and the lowering of mortgage rates. But financial market stability is not here yet and additional narrowing of spreads is necessary (see charts 1-3).

With regard to the underlying approach the Fed has taken compared with the Bank of Japan's strategy when its policy rate was held at zero during 2001-2006, Bernanke noted that the Fed's methodology is different because it is operating from the asset aside of the balance sheet as opposed to the Bank of Japan's procedure when it operated on the liability side of the balance sheet when it was managing reserves. In the absence of a single measure that signifies the FOMC's monetary policy stance, Bernanke indicated that the Fed would communicate with the public about how the balance sheet will be managed and the criteria on which decisions are based through its policy statements and other means.

The exit strategy of the Fed is important because there is a growing concern about the inflationary threat from the extraordinary monetary policy measures put in place to support the working of the financial system. The exit strategy as outlined in this speech consists of automatic unwinding as improving conditions in credit markets will reduce the need to tap into some of the facilities. Some programs will be legally not permissible and unnecessary because they have been set up under emergency provisions. In addition, several short-term programs such as currency swap arrangements and commercial paper purchases and loans will be allowed to unwind as they become redundant. Bernanke indicated that the Fed will be able to reduce the balance sheet as necessary depending how credit markets and economic conditions evolve in the months ahead.

In the context of financial market stability, Bernanke calls on history to stress that a modern economy cannot grow if its financial system is not operating effectively. Bernanke noted that in order to support and mend the fragile financial system more capital injections and guarantees may become necessary to ensure stability and normalization of credit markets. He suggested that purchases of troubled assets, a provision of asset guarantees, and/or purchase of assets from financial institutions in exchange for cash and equity in bad banks are other avenues through which fiscal policy could support the financial system. Also, reducing preventable foreclosures would be useful in reducing mortgage losses and promoting financial stability. In sum, the conclusion we draw here is that additional fiscal policy stimulus is necessary to ensure the working of the financial system and revival of economic activity.

Lower Prices and Weak Non-Oil Imports Translate to Smaller Trade Gap

The trade balance of the U.S. economy narrowed to $40.4 billion in November from $56.7 billion in October. A 12.0% drop in nominal imports of goods and services partly due to lower imported oil prices was the main reason for the reduction in the trade gap. Weak economic conditions in the U.S. have resulted in lower imports, while a similar status abroad has led to a 5.8% drop in nominal exports of goods and services.

After adjusting for inflation, the trade deficit of goods narrowed to $39.5 billion in November vs. $45.6 billion in October. Non-petroleum imports of goods fell 6.0% and that of petroleum imports dropped 10.0% in November. The trade deficit narrowed vis-à-vis China ($23.1 billion vs. $27.9 billion in October), Mexico ($3.5 billion vs. $4.8 billion in October), Canada ($3.3 billion vs. $5.95 billion in October), Japan ($4.9 billion vs. $6.1 billion in October), and the Euro-area ($4.4 billion vs. $7.7 billion in October) during November.

Download Full Daily Global Commentary