Finance counsels

Federal Reserve Chairman Ben S. Bernanke laid more groundwork for exiting his record expansion of credit without saying when he’ll take the first step.

Bernanke yesterday described how the Fed might use tools such as interest it pays on banks’ deposits to tighten credit “at some point.” In congressional testimony, he said a potential increase in the Fed’s discount rate would be part of the “normalization” of lending “before long” and wouldn’t signal a change in the outlook for monetary policy.

The 56-year-old Fed chief and his fellow policy makers are trying to determine when to tighten credit with unemployment at 9.7 percent and the world’s largest economy forecast to grow at the fastest pace since 2005. Bernanke also said the U.S. still requires a “highly accommodative” Fed policy, reiterating that low rates are warranted for an “extended period.”

Bernanke “kind of walked a fine line,” said Vincent Reinhart, a former Fed monetary-affairs director who’s now a resident scholar at the American Enterprise Institute in Washington. “He wants to reassure investors that they have an exit plan but at the same time not lead them to believe that they’ll head for the exits anytime soon.”

Treasuries fell, pushing the yield on two-year securities to 0.88 percent from 0.83 percent on Feb. 9 and to 3.69 percent on 10-year notes from 3.65 percent. The Standard & Poor’s 500 Index slipped 0.2 percent to 1,068.13 in New York. The dollar climbed 0.6 percent to $1.3711 per euro from $1.3797.

Expanding Strategy

Expanding on a strategy detailed in July, Bernanke said raising the interest rate paid on funds deposited by banks at the Fed, as well as so-called reverse repurchase agreements that temporarily drain cash from the banking system, will probably be the first tools for tightening credit.

Bernanke said he doesn’t expect the Fed “in the near term” to sell the $1.43 trillion of housing debt being purchased through next month, “at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery.” Fed officials may decide “in the future” to sell securities, he said in the testimony prepared for a hearing that was postponed because of a snowstorm.

Bernanke said “one possible sequence” of the exit strategy involves first testing tools for draining reserves “on a limited basis.” Then, “as the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates,” he said.

‘Firming’ Policy

The Fed would then execute the “actual firming of policy” by raising the interest rate on bank reserves, Bernanke said. Congress granted the Fed the power in October 2008 as part of the law creating the $700 billion Troubled Asset Relief Program.

“Changes in the interest rate will be broadly telegraphed,” said Anthony Crescenzi, senior vice president at Pacific Investment Management Co. in Newport Beach, California, which runs the world’s biggest mutual fund payday loans. “The first thing that will happen is that there will be a language change, taking ‘extended period’ out” of the Fed’s public policy statement.

“By the time we see scaled-up operations” to drain reserves, “they will seem like an afterthought,” Crescenzi said.

At the last FOMC meeting, Kansas City Fed President Thomas Hoenig dissented from the decision to maintain the pledge of low rates for an “extended period.”

“We have moved through the crisis,” Hoenig said in a Feb. 4 speech in Oklahoma City. “We are beginning to think about a growth rate over 3 percent. We need to change the language.”

Policy Guide

Bernanke said the Fed may temporarily replace the federal funds rate as a policy guide with interest it pays on banks’ deposits should fed funds become a “less reliable indicator than usual.”

Such a change may raise governance questions for the Federal Open Market Committee. While the Washington-based Board of Governors and regional Fed presidents together vote on the federal funds rate on the FOMC, the governors alone vote on the deposit rate, meaning the five presidents who sit on the committee would have no official say.

One solution may be to have the FOMC vote on a directive to the New York Fed to increase or lower pressure on bank reserves to achieve a target or range for short-term interest rates. The Board vote on interest on reserves would then follow the FOMC’s decision, much as it did when they raised or lowered the discount rate following the committee’s changes to the federal funds rate.

Market Evolution

Bernanke said “no decision has been made on this issue” of which target the Fed will use. “We will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn,” Bernanke said.

Separately yesterday, Dallas Fed President Richard Fisher said in a Dallas speech that policy makers must shrink the balance sheet with the “deftness to minimize credit-market disruptions and the timeliness to avoid inflationary pressures.”

The Fed may be months away from tightening credit. U.S. central bankers will begin raising rates in the fourth quarter and increase the benchmark lending rate to 0.75 percent by the end of the year, according to the median estimate of economists surveyed by Bloomberg News in February.

The U.S. economy will expand 3 percent this year, according to the median estimate. The timing and speed of rate increases may also depend on how quickly the economy can begin to generate job growth.

Some economists said Bernanke left out what investors are really watching for: when the Fed will move.

“I don’t really see a whole lot of clarity of the timing of actions,” said Conrad DeQuadros, senior economist and partner at RDQ Economics LLC, a New York research firm he founded with John Ryding, a fellow former Bear Stearns Cos. economist.

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