Bernanke: Fed able to foil inflation when time comes

on July 21 2009 7:56 AM

Federal Reserve Chairman Ben Bernanke said the huge amounts of money the U.S. central bank has pumped into the economy will not undercut its ability to push borrowing costs higher when the time is ripe.

Stressing that the weak U.S. economy will likely warrant exceptionally easy policies for a long time to come, Bernanke outlined in a newspaper opinion piece how the Fed could raise interest rates even with cash flooding the financial system.

Accommodative policies will likely be warranted for an extended period, Bernanke wrote in the article published on the Wall Street Journal's web site. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.

The outline of the Fed's exit strategy from the extraordinary monetary policy easing it has undertaken offers a preview of testimony Bernanke will deliver to Congress on Tuesday as he presents the Fed's twice-a-year economic report.

Investors showed little reaction to the article.

It doesn't look like he's sounding too anxious or urgent about removing excess stimulus from the system, said Sue Trinh, a senior currency strategist at RBC Capital Markets in Sydney.

The Fed has lowered benchmark overnight rates to near zero and pumped more than $1 trillion into financial markets to counter the worst banking crisis since the Great Depression and one of the most severe recessions in decades.

Some economists have expressed alarm that the U.S. central bank's aggressive policies may have sown the seeds for an outburst of inflation when economic activity picks up.

Bernanke acknowledged the massive accumulation of bank reserves at the Fed could fuel unwanted price pressures when banks find more opportunities to lend money.

FED'S TOOL BOX

But to soothe those worries, he described in detail the tools the Fed has at its disposal to raise borrowing costs and withdraw that money from circulation.

Fed officials have devoted extensive energy to thinking about their strategy for exiting from one of the most aggressive central bank responses to a financial crisis in U.S. history, he said.

We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner, he said.

Chief among these is the Fed's ability to pay interest on the reserves that banks hold at the Fed, Bernanke said. The interest rate the Fed pays on those reserves sets a floor under short-term rates.

If the Fed raises that rate, it can discourage banks from lending because banks will not want to lend money at rates lower than they can earn from the Fed, he explained.

Bernanke said the U.S. central bank also has other ways to raise short-term interest rates and limit the broad growth of money in the financial system.

For instance, it can arrange so-called reverse repurchase agreements with financial firms. The Fed would sell securities from its portfolio, taking cash out of the system, with an agreement to buy them back at a higher price at a later date.

The Fed could also offer term deposits similar to certificates of deposit to banks. Bank funds held at the Fed in such instruments would not be available for lending.

He also said the Treasury could issue securities and leave the funds on deposit with the Fed. Alternatively, he said the Fed could sell some of the securities it has accumulated.

While policy-makers have more fully turned their attention to how they might withdraw support for the economy, as opposed to how they might increase it, Bernanke made clear the central bank did not believe the economy was healthy enough for officials to remove easy money policies any time soon.

As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period, Bernanke said.

While interest rate futures markets have toyed with the notion the U.S. central bank could begin to push interest rates up by the end of the year, most economists think a rate hike is further off.

In a research note, economists at Goldman Sachs said they did not see anything in Bernanke's remarks that was at odds with their forecast that the Fed would hold rates near zero at least through the end of next year.

(Additional reporting by Kevin Plumberg in Hong Kong; Editing by Neil Fullick)

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