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Federal Reserve Interest RatesWhat are Bernanke's options?2/10/10 - Bernanke now faces the delicate task of beginning to pull the central bank out of its extraordinary effort to prop up the economy.He and the other Federal Reserve Governors must determine when and how the Fed will raise short-term interest rates. Related is the issue of how to manage, and eventually shrink, the record $2.2 trillion balance sheet that the Fed amassed as it pumped vast sums of money into the economy. As a policy tool, Bernanke is expected to consider a little-known mechanism — referred to as the interest rate on excess reserves — that gives the Fed leverage over $1.1 trillion in bank deposits. Most of those deposits were created as the Fed gobbled up mortgage-backed securities and Treasury notes and bonds during the financial crisis. The banks in turn parked the funds at the Fed as reserves. The Fed wants to make sure that banks do not reduce their reserves too quickly, because it could create inflationary pressures as banks step up their lending. To achieve its goal, the central bank will raise the interest rate on excess reserves. It also plans to lift its target for the fed funds rate — what banks charge one another for overnight loans. With unemployment at 9.7 percent, the Fed may be months away from raising rates, but it is discussing the plan now to prepare the markets and tamp down inflation fears. If the Fed raises interest rates too hastily, it could choke off the fragile recovery. If it dallies, it might set off market jitters about rising prices. The Fed’s balance sheet has nearly tripled since the summer of 2007. At the end of that year, the Fed found new ways to lend to banks, and in early 2008, it began to cut interest rates aggressively, pushing the target rate for fed funds to nearly zero in December 2008. By that month, the Fed’s balance sheet had ballooned to $2.2 trillion as the central bank doled out loans to commercial banks, issuers of commercial paper, foreign central banks, and AIG. Many of those programs are winding down. Two of the biggest — the Fed’s purchase of $1.25 trillion of mortgage-backed securities and of about $175 billion in debts guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae — are to be completed by March 31. The Fed in essence created new money to buy those securities, and now holds $1.1 trillion in reserves that the banks can demand when they wish. Bernanke has argued that the new rate will eventually serve as an interest-rate floor, with the discount rate — the rate at which the Fed lends directly to banks — functioning as the ceiling, and the fed funds rate fluctuating in between them. Looking longer term, Bernanke has four other tools that could be used gingerly to tighten monetary policy. The first is reverse repurchase agreements, or reverse repos, in which the Fed would sell securities from its portfolio with an agreement to buy them back at a slightly higher price at a later date. The second is term deposits, analogous to the certificates of deposit banks offer to customers. Third, the Treasury could sell bills and deposit the proceeds at the Fed. Finally, the Fed could sell some of its long-term securities, including those backed by mortgages, taking more money out of the system. That strategy would carry risk given that the Fed’s ownership of such securities is helping keep mortgage rates low and support the housing market. |
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