Monday, December 7, 2009

How Ben Bernanke Plans to Drain Funds from the System

Fed Chairman Ben Bernanke's speech today before the Economic Club of Washington D.C. did not provide much as far as market moving data, but I think it provided his most clearest comments on how he intends to drain funds from the system, whenever that event may occur. Here's what he had to say on that topic:
...our balance sheet is already beginning to adjust, because improving financial conditions are leading to substantially reduced use of our lending facilities. The balance sheet will also shrink over time as the mortgage-backed securities and other assets we hold mature or are prepaid. However, even if our balance sheet stays large for a while, we will be able to raise our target short-term interest rate--which is the rate at which banks lend to each other overnight--and thus tighten financial conditions appropriately.

Operationally, an important tool for adjusting the stance of monetary policy will be the authority, granted to us by the Congress last year, to pay banks interest on balances they hold at the Federal Reserve. When the time comes to raise short-term interest rates and thereby tighten policy, we can do so by raising the rate that we offer banks on their balances with us. Banks will be unwilling to make overnight loans to each other at a rate lower than the rate that they can earn risk-free from the Fed, and so the interest rate we pay on banks' balances will tend to set a floor below our target overnight loan rate and other short-term interest rates.

Additional upward pressure on short-term interest rates can be achieved by measures to reduce the supply of funds that banks have available to lend to each other. We have a number of tools to accomplish this. For example, through the use of a short-term funding method known as reverse repurchase agreements, we can act directly to reduce the quantity of reserves held by the banking system. By paying a slightly higher rate of interest, we could induce banks to lock up their balances in longer-term accounts with us, making those balances unavailable for lending in the overnight market. And, if necessary, we always have the option of reducing the size of our balance sheet by selling some of our securities holdings on the open market.

As always, the most difficult challenge for the Federal Open Market Committee will not be devising the technical means of unwinding monetary stimulus. Rather, it will be the challenge that faces central banks in every economic recovery, which is correctly judging the best time to tighten policy.

The full speech is here.

1 comment:

  1. Tighten monetary policy by raising the rates paid to banks on their balances at the fed? Unless I'm mistaken, that would be accomplished by increasing their reserves - using what, printed money? Now the fed has to pay (increase reserves) even more in the future if tigtening continues? I'm having a hard time seeing how this would be considered a useful tool.

    I'm no economist, but if the balances were originally created by taking bad loans from the banks, then it would be interesting to know how these reserves would have any buyers in the open market.