A modest U.S. economic recovery still warrants the Federal Reserve's ultra-low interest rate policy, but the central bank stands ready to remove stimulus once the expansion looks solid, Chairman Ben Bernanke said on Thursday.
Testifying before the U.S. House of Representatives Financial Services Committee, Bernanke offered a brief overview of the tools the Fed intends to use to reverse the emergency measures taken to grapple with the worst financial crisis since the Great Depression.
The economy continues to require the support of accommodative monetary policies, Bernanke told lawmakers. 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.
In response to the crisis, the Fed slashed interest rates effectively to zero. It also embarked on an unprecedented asset purchase program totaling over $1.7 trillion -- buying mortgage debt and Treasury bonds in an effort to push borrowing costs down even further.
Bernanke argued these programs had helped to improve conditions in mortgage markets, which were at the epicenter of a financial meltdown that began when falling home prices spurred a wave of defaults.
He also maintained these purchases did not expose taxpayers to any additional credit risk because the mortgage debt purchased originated with agencies like Fannie Mae and Freddie Mac, which have always had the U.S. government's implicit guarantee.
The Fed chairman emphasized the importance of the central bank's authority, granted by Congress after the crisis was already under way, to pay interest to banks for their excess reserves.
Bernanke said, once economic activity and financial markets were healed, the Fed would like to get outstanding credit to the banking system back to pre-crisis levels, beneath $1 trillion. Total bank credit, sometimes referred to as the Fed's balance sheet, currently stands at $2.3 trillion.
He also cited reserve-draining operations, such as reverse repurchase agreements and a term deposit facility, that would again provide financial institutions with a monetary incentive not to lend when the Fed decides there is a risk of inflation.
The use of reverse repos and the term deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so, Bernanke said.
A panel of top economists, slated to testify after Bernanke, noted in remarks released before their hearing that this strategy poses some dangers, including exposing the central bank to potential credit risk.