Bernanke discusses plan to unwind Fed's balance sheet
The traditional tools the Federal Reserve uses to conduct monetary policy are open market operations, the discount rate, and reserve requirements.The Federal Open Market Committee (FOMC) uses these tools to stabilize prices and promote economic growth and full employment. Over the course of a typical business cycle, the FOMC will adjust the federal funds rate, historically the primary policy tool, to achieve the Fed's dual mandate, thus promoting stable long-term economic growth.
The FOMC's decision to lower the federal funds rate proved to be insufficient for the most recent financial crisis. While the rate has remained at a historically low range between 0 and 25 basis points since December 2008, the Federal Reserve also created a number of alternative programs to thaw credit markets and encourage an economic recovery while keeping prices stable. In the process the size of the Fed's balance sheet has more than doubled, leading to significant increases in measures of the money supply.
According to Ben Bernanke, chairman of the Federal Reserve's Board of Governors, the Fed will have to tighten monetary conditions at some point to counteract potential inflationary pressures. In his semiannual address to Congress on Feb. 24, 2010, Bernanke said, "Notwithstanding the substantial increase in the size of its balance sheet associated with the purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time."
He has discussed three options to aid in the "unwinding" of the Fed's balance sheet. The first option involves the paying of interest on excess reserves. Congress granted this authority to the Federal Reserve in the Economic Stabilization Act of 2008. (Since December 2008 the Fed has been paying interest on both excess and required reserves.) According to Bernanke's testimony, "By increasing the rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks."
A second tool that the Fed can use to reduce the excess reserves financial institutions are holding is a reverse repurchase agreement, or reverse repo. Bernanke explained that, "in a reverse repo, the Federal Reserve sells a security to a counterparty with an agreement to repurchase the security at some date in the future. The counterparty's payment to the Federal Reserve has the effect of draining an equal quantity of reserves from the banking system."
Bernanke also mentioned that "the Federal Reserve has the option of redeeming or selling [Treasury] securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Federal Reserve's balance sheet."
Finally, the Federal Reserve has been working on a plan to offer depository institutions "term deposits." Bernanke described term deposits as being like "certificates of deposits that the institutions offer to their customers." According to Bernanke, "The Federal Reserve would likely auction large blocks of such deposits, thus converting a portion of depository institutions' reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves."
The Fed chairman believes a return to the traditional targeting of the federal funds rate may not occur for some time. In his testimony, Bernanke said, "It is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn."
Ultimately, the Federal Reserve's goal is to reverse the monetary stimulus before inflationary pressures take hold while avoiding a premature tightening that might dampen economic recovery.
By Amy B. Hennessy, economic and financial education specialist, Atlanta
Bernanke, Ben. 2010. Testimony prepared for delivery to the Committee on Financial Services, U.S. House of Representatives, Washington, D.C. February 10.
———. 2010. Semiannual Monetary Policy Report to the U.S. Congress. February 24.
Lothian, James R. 2009. U.S. monetary policy and the financial crisis. Federal Reserve Bank of Atlanta, Center for Financial Innovation and Stability, CenFIS Working Paper 09-01, December.
April 29, 2010