In his semi-annual testimony before the House Financial Services Committee, Fed Chairman Ben Bernanke described the myriad of tools in the Fed's arsenal to withdraw liquidity.
As widely expected, Bernanke reiterated his stance that the fed funds rate will remain at exceptionally low levels for an extended period.
Bernanke and his colleagues have pledged the low interest, using the same phrases, on February 18, February 10, and in the latest FOMC statement.
However, while the Fed does not aim to tighten conditions for households and business, it is will deploy a number of strategies to withdraw liquidity in the financial system.
Bernanke first reiterated the closing of special lending facilities for banks and tighter credit at the regular discount-window. The Fed's latest move was to raise the discount rate by 0.25 percent on February 18.
The Chairman and his team has also been gradually slowing the pace of their purchase of mortgage-backed securities. The program was first started to support the ailing mortgage lending and housing market.
Additionally, the Fed could also use the interest it pays on the excess reserves from banks. By increasing the interest in these reserves, the Fed can put significant upward pressure on all short-term interest rates. Bernanke states that this pressure will also be reflected in longer-term interest rates and in financial conditions more generally.
Reverse repurchase agreements is another tool to withdrawal liquidity. In these transactions, the Fed essentially borrows short term from primary dealers, thus raising the borrowing cost in this market.
The Fed Reserve also has plans to auction termed deposits to banks, which acts as a source to drain capital as banks park excess liquidity in these deposits.
In addition, Bernanke stated, FOMC has the option of redeeming or selling securities as a means of reducing outstanding bank reserves and applying monetary restraint.
Whenever the Fed sells securities, it drains money out of the financial system.