- The Washington Times - Thursday, July 23, 2009

Federal Reserve Chairman Ben S. Bernanke assured the Senate banking committee Wednesday that the Fed has developed an “exit strategy” that would enable the central bank to raise short-term interest rates to fight inflation when it eventually becomes necessary.

Mr. Bernanke was confident the Fed will achieve this goal despite the fact that it has injected extraordinary amounts of liquidity throughout the banking system in fighting the worst financial crisis since the Great Depression.

Some members of Congress, economic analysts and policymakers worry that the trillions of dollars in liquidity that the Fed has created to thaw frozen credit markets will give rise to rapid inflation once the economy begins to recover. Much of this liquidity takes the form of massive reserve deposits that banks hold on account at their Federal Reserve district banks.

Beyond the reserves banks are required to hold, these excess reserves form the raw material for lending opportunities that will arise as the economy begins to expand. The Fed’s goal is to make sure the excess reserves do not finance a lending binge that could prove to be inflationary.

One of Mr. Bernanke’s key objectives was to “reassure the world that the Fed has an ‘exit strategy,’ meaning that it is ready, willing and able to withdraw its extreme monetary stimulus in ‘a smooth and timely manner,’ ” said Nigel Gault, chief U.S. economist of IHS Global Insight.

Mr. Bernanke also told Congress in his semiannual testimony this week that the central bank “believes that a highly accommodative stance of monetary policy will [continue to] be appropriate for an extended period.”

That will make it all the more crucial that the Fed can tighten the money spigot when the time arrives.

Mr. Bernanke noted that some of the Fed’s extraordinary lending programs will unwind naturally as financial markets continue to improve. Since the end of 2008, for example, total Fed credit extended to banks and other financial institutions has already declined from $1.5 trillion to $600 billion, he said. He expects this process to continue as long-term securities held at the Fed mature.

Even while reserves remain very bloated, the Fed can control short-term interest rates. Its most important tool, Mr. Bernanke said, was the Fed’s ability to pay interest on the reserves. The Fed could raise this interest rate.

“In general, banks will not supply funds to the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve,” the central bank declared in its policy report to Congress.

The Fed can also tighten its policy by reducing the overall level of reserves. It can achieve this by engaging in large-scale “reverse repurchase agreements.” This would involve selling securities while agreeing to buy them back in the future. The Fed could also offer banks “term deposits,” which earn interest but cannot be used as reserves.

“If necessary, another means of tightening policy is outright sale of our holdings of longer-term securities,” which, in addition to raising short-term rates, would have the benefit of putting upward pressure on long-term rates, Mr. Bernanke confidently assured Congress.

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