Federal Reserve Chairman Ben Bernanke on Wednesday detailed how the U.S. central bank will begin to wean the economy off its extraordinary stimulus, even as he stressed it was not yet time to do so.
Bernanke said the Fed would likely begin tightening monetary policy by removing cash from the financial system before it turns to raise benchmark short-term interest rates.
In his most comprehensive description to date of how the Fed aims to dismantle its extensive emergency economic supports, he also said the central bank could soon raise the discount rate it charges banks for emergency loans, but stressed that would not be akin to a tightening in monetary policy.
Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions, Bernanke said in remarks prepared for a hearing of the House of Representatives Financial Services Committee.
The hearing on the Fed's exit strategy was postponed because of heavy snow, but the Fed released Bernanke's prepared remarks. Some lawmakers have worried the Fed's aggressive stimulus for the economy could spark inflation.
The Fed's willingness to raise the discount rate, which could come before its next policy meeting March 16, signals it believes that financial markets are working better, a precondition for raising interest rates.
The Fed's move toward withdrawing monetary policy accommodation contrasted with the Bank of England, which is contemplating adding more money to Britain's fragile economy.
Bernanke's comments were seen as suggesting the Fed would tighten before the European Central Bank, which is facing debt crisis among some euro-zone countries, boosting the dollar against the euro. U.S. stock indexes were mostly flat.
Big Wall Street firms polled by Reuters last week expect the Fed to raise rates in the final three months of this year.
The U.S. central bank has pumped more than $1 trillion into the economy after it slashed benchmark rates to near zero to combat the worst financial crisis since the Great Depression.
While the economy has grown for the past two quarters, the unemployment rate is at a lofty 9.7 percent.
Bernanke said the outlook for monetary policy currently remains about the same as it was at the Fed's last policy meeting on January 26-27, and he repeated the Fed's pledge to hold interest rates exceptionally low for an extended period.
He said the Fed could begin by testing tools to absorb the massive amount of reserves it had pumped into the banking system, such as reverse repurchase agreements and term deposits for banks at the central bank, in small amounts to prepare markets.
As the time to tighten financial conditions drew nearer, the Fed could ramp up reserve-draining operations. Absorbing reserves would give policymakers tighter control over short-term interest rates, Bernanke said.
Ultimately, the Fed would increase the rate it pays on reserves banks hold at the central bank as its way to take its foot off the monetary accelerator pedal. Raising the interest rate on reserves would encourage banks to park funds with the Fed, taking the money out of circulation.
The Fed has greatly expanded its balance sheet with purchases of mortgage-related debt as part of its efforts to revive the economy.
Bernanke said the Fed is not likely to sell any of those holdings in the near term, at least not until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery.
However, when the recovery has advanced and more tightening is needed, the Fed could sell securities, Bernanke said. Any such sales would likely be gradual and markets would receive ample warning, he said.
DISCOUNT RATE HIKE IN THE OFFING
The Fed will also return its vast array of emergency lending measures to pre-crisis norms, including raising the discount rate and shortening the duration of loans at its emergency lending window, Bernanke said.
The Fed pulled the discount rate closer to the federal funds rate during the severe credit crunch to encourage banks to use it to obtain short-term funding. Before the crisis hit, the discount rate was 1 percentage point higher than the benchmark borrowing costs. It now stands at 0.5 percent, while the federal funds rate is between zero and 0.25 percent.
With the Fed's balance sheet abnormally large, controlling the federal funds rate can be difficult, Bernanke said. During the transition, the Fed will likely communicate its policy stance through a combination of the interest paid on reserves and targets for reserve quantities.
(Editing by Neil Stempleman)