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Friday, August 27, 2010

Bernanke: Fed Ready to Act If Economy Deteriorates Further

Today in Jackson Hole, Wyoming, Federal Reserve Chairman Ben Bernanke outlined numerous strategies the Fed could implement to provide additional stimulus to the economy, but considering the unknowns and costs associated with each option, stressed that they would only be implemented if the economy weakens further. Bernanke focused on three main tools: (1) additional purchases of longer-term securities, (2) modifying the FOMC’s communications, and (3) reducing the interest on excess reserves.

Bernanke asserted, “additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions.” However, he warned that with little experience using this option, precise knowledge of its impact is unknown. He also warned that continued expansion of the Fed’s balance sheet could reduce the public’s confidence in the Fed’s ability to unwind much of the stimulus and simultaneously control inflation.

A second strategy would be alter the FOMC’s communications regarding inflation expectations. The FOMC could “modify the language in the statement to communicate to investors that it anticipates keeping the target for the federal funds rate low for a longer period than is currently priced in markets. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.”

“A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System… On the margin, a reduction in the IOER rate [interest on excess reserves] would provide banks with an incentive to increase their lending to nonfinancial borrowers or to participants in short-term money markets, reducing short-term interest rates further and possibly leading to some expansion in money and credit aggregates.” Currently, the Fed pays 25 basis points on excess reserves. Bernanke said the rate could be reduced to ten or even zero basis points. However, given current circumstances, the impact of reducing the rate would likely be “relatively small.”

Bernanke dismissed the idea that the FOMC should increase its inflation goals, saying “I see no support for this option on the FOMC.” Recently several economists have proposed increasing the Fed’s medium-term inflation goals beyond levels consistent with price stability.

Bernanke stressed that these plans would only be implemented if the economy showed further signs of weakness, as all of the options carry costs and consequences. The economy continued to expand, albeit at a slower pace than initially hoped. Bernanke affirmed that “falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation.”

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