As Daily Finance wrote last weekend, interest paid on reserves is a relatively new Fed tool, introduced in October 2008. The idea is that the Fed raises the interest rate it pays to banks for the reserves they deposit with the central bank. Currently, that rate is 0.25%. A higher rate paid on those reserves should make banks less likely to lend unless they can get a better risk-free return than the Fed is promising to pay. That would start a chain reaction, in which the Fed funds rate goes up, then the prime rate goes up and finally the rates consumers pay will go up.
Using this tool, Bernanke said in his testimony, "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 market at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks."
Awaiting Clearer Economic Signs
But again, no one should think this change will happen any time soon. Bernanke said current moves by the Fed are "not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about as it was at the time of the January meeting of the FOMC."
At that Federal Open Market Committee meeting on Jan. 27, Bernanke repeated the information that many stimulus programs have already wound down or are near their end. The FOMC didn't call for an immediate move toward higher rates as a way to avoid inflation. Instead the FOMC said, "Business spending on equipment and software appears to be picking up, but investment in structures is still contracting, and employers remain reluctant to add to payrolls."
But Bernanke did indicate that additional moves aimed at normalizing Federal Reserve operations have started. For example, the Fed has reduced the maximum duration of discount-window loans to 28 days from the 90 days it was offering during the crisis. He also said that "before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate" as market conditions improve.
Needed: A Better Way to Deal With Big Banks
The Fed chairman repeated previous statements that the central bank doesn't anticipate taking any losses from the massive stimulus over the past few years. He said he even expects full repayment on loans of $116 billion to Bear Stearns and AIG. He added, "these loans were made with great reluctance under extreme conditions and in the absence of an appropriate alternative legal framework." He also repeated previous pleas for a fix by saying "we strongly support the establishment of a statutory regime for the safe resolution of failing, systemically important nonbank financial institutions."
In addition to the using the interest paid on banks' reserves at the Fed as a tool for winding down the stimulus, Bernanke mentioned other methods as well:
- Large-scale reverse purchase agreements (reverse repos), which involve Fed selling securities from its portfolio with an agreement to buy them back at a slightly higher price at a later date. Reverse repos drain liquidity from the money supply as purchasers of them transfer cash to the Fed.
- Offer term deposits to banks. These are similar in concept to the certificates of deposit that banks offer to their customers. Money held in such term deposits wouldn't be available to the federal funds market.
- Reduce the Fed's reserves by selling a portion of its holdings of long-term securities in the open market.
Clearly, the Federal Reserve is preparing for unwinding the stimulus when the time comes -- whenever it decides that time is right -- but it's not ready to push the start button now.