Fed takes first step on long unwinding road

Federal Reserve chairman Ben Bernanke has started to outline the central bank's strategy for reeling in stimulus money once the US economic recovery is more firmly rooted.

Bernanke said yesterday the Fed would likely start to tighten credit by boosting the interest rate it pays banks on money they leave at the central bank. Doing so would raise rates tied to commercial banks' prime rate and affect many consumer loans. Companies and ordinary Americans would pay more to borrow.

Bernanke's remarks on the Fed's eventual pullback of economic aid come despite signs that the global recovery remains fragile. Europe is trying to contain a debt crisis. And President Barack Obama is pushing for tax breaks to generate jobs.

Bernanke indicated the Fed was still months away from raising rates or draining most of the stimulus money it injected to rescue the financial system. He said the recovery still needed support from record-low interest rates.

The Fed chief used his remarks to explain how the central bank will try to unwind the stimulus measures without tipping the economy back into recession.

Using the rate it pays on banks' excess reserves to affect credit would be a new strategy for the Fed. Since the 1980s, its main lever to tighten or loosen credit has been the federal funds rate. That rate is now at a record low near zero.

The rate paid on banks' excess reserves is 0.25 per cent. Boosting that rate would give banks an incentive to keep money parked at the Fed, rather than lend it. It also would cause the funds rate to rise, economists say. Adjusting the interest paid on banks' excess reserves helps stabilise the funds rate when the financial system is awash in cash, as it is now.

Paying interest on the reserves is a relatively new tool for the Fed, having been authorised by a 2008 law. Many foreign central banks rely on it. The Fed started paying interest on the reserves at the height of the financial crisis in October 2008.

Deciding when and how to remove all the stimulus is the biggest challenge for Bernanke in his second term, which started last week. Reeling in the stimulus too soon risks short-circuiting the recovery. That could send unemployment up. Yet if the Fed keeps its stimulus measures in place for too long, they could help unleash inflation.

Bernanke repeated the Fed's pledge to hold rates at record lows for an "extended period". Economists think that means for at least six more months. But Bernanke cautioned that the Fed eventually will need to raise rates to ease inflationary pressures.

The Fed is still weighing the order of steps it can take to reel in the stimulus. Under one scenario, the Fed would first use its tools to drain money from the financial system. Then it would start pushing up rates throughout the economy by boosting the rate paid on banks' excess reserves, Bernanke said. But if a faster exit is needed, the Fed could raise the rate on reserves even as it's using its other tools to pull money from the financial system.

The Fed is fine-tuning one tool to withdraw money: By selling securities from its portfolio with an agreement to buy them back later. And it is moving ahead on a proposal to let banks set up the equivalent of certificates of deposit at the central bank. This, too, would help it mop up money pumped into the economy and prevent inflation from flaring later.

Some of the Fed's major economic support programmes

* Programme to buy US$1.25 trillion ($1.78 trillion) in mortgage securities from Fannie Mae and Freddie Mac. The goal is to drive down mortgage rates and bolster the housing market. It is slated to end on March 31, but that could extend if the economy is deemed too weak. So far it's bought US$970.2 billion of the securities.

* Programme to buy about US$175 billion in debt from Fannie Mae and Freddie Mac by the end of March. So far, US$164.1 billion has been bought. This programme also is designed to support the housing market.

* Term Auction Facility to provide low-cost loans to banks. The Fed was lending an average of US$38.5 billion in the week that ended on February 3. It is slated to end on March 8.

* Term Asset-Backed Securities Loan Facility (TALF for short) is designed to spark lending to consumers and small businesses at cheaper rates. Use of TALF averaged US$47.3 billion over the week ended February 3. On March 31, most of that programme will end. An exception will be a component that seeks to bolster the market for newly issued commercial real estate securities. That part of the programme will end on June 30.

* Primary Dealer Credit Facility, which folded on February 1, gave emergency loans to investment houses. Loans hadn't been drawn in months.

* Programmes to backstop the "commercial paper" market. This involves short-term financing used to pay salaries and supplies, and one to bolster the money market mutual fund industry. Both had also fallen out of use and ended on February 1.

* Programme to buy US$300 billion in Treasury securities was shut down at the end of October. That programme was designed to force rates down for mortgages and other consumer debt, to get Americans to spend more.

- AP