Alert February 16, 2010

FRB Chairman Bernanke Announces Exit Strategy for Crisis Response Programs, Including by Raising Interest Rates on Reserve Balances

In written testimony to the House Financial Services Committee, FRB Chairman Ben Bernanke outlined the FRB’s exit strategy from the extraordinary lending and monetary policies it established in response to the financial crisis and recession which have caused the FRB’s balance sheet to grow to more than $2.2 trillion.  “As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets,” Chairman Bernanke stated.  Instead, Chairman Bernanke indicated that the FRB is turning to the interest rate paid on reserves – currently at 0.25% ‑ as an alternative short term interest rate.  The FRB was granted the authority to pay interest on reserves in October 2008.  As of February 3, 2010, U.S. banks had more than $1.1 trillion on deposit with the Federal Reserve Banks.  An increase in the interest rate paid on reserves would encourage banks to increase their reserve deposits, which would result in less money in the banking system.

Chairman Bernanke also highlighted two other tools the FRB is developing to remove liquidity from the financial system: reverse repurchase agreements and term deposits.  Under the reverse repurchase agreements, the FRB sells a security to a counterparty with an agreement to repurchase the security at some date in the future.  Chairman Bernanke stated that “the counterparty’s payments to the FRB has the effect of draining an equal quantity from the banking system.”  He further stated that the FRB has enhanced its ability to use reverse repurchase agreements to absorb very large quantities of reserves.  Chairman Bernanke indicated that the FRB’s capability to carry out these transactions with primary dealers, using the its holdings of Treasury and agency debt securities, has already been tested and is currently available.  To further increase its capacity to drain reserves through reverse repurchase agreements, Chairman Bernanke stated that the FRB is in the process of expanding the set of counterparties with which it can transact and developing the infrastructure necessary to use its mortgage-backed securities holdings as collateral in these transactions.

The FRB has also been developing term deposits for depository institutions, which are roughly analogous to certificates of deposit.  Under the term deposit facility, depositor banks would receive a separate account that would earn interest and mature within a year.  Such term deposits could not be used by banks to meet their short-term liquidity needs and would not be counted as reserves.  Chairman Bernanke stated that the FRB would likely auction large blocks of such deposits.  He expects the FRB “to conduct test transactions this spring and to have the facility available if necessary shortly thereafter.”  Chairman Bernanke stated that reverse repurchase agreements and term deposits would “together allow the [FRB] to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so.”

Chairman Bernanke gave no indication of when the FRB will tighten its monetary policy, but stated that the “sequencing of steps and the combination of tools that the [FRB] uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments.”  “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.  “The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves.” 

Chairman Bernanke said that he has no plans to sell the $175 billion in debt and $1.25 trillion in mortgage-backed securities of Fannie Mae and Freddie Mac that the FRB expects to have purchased by the end of March 2010.  He noted that the debt and mortgage-backed securities are being allowed to mature and run off the FRB’s balance sheet, but stated that the FRB could begin selling such securities “when the economic recovery is sufficiently advanced.”  He further stated that any such sales “would be at a gradual pace, would be clearly communicated to market participants and would entail appropriate consideration of economic conditions.”

Chairman Bernanke noted that the terms of discount window lending are returning to normal after an extended period of longer maturities and lower interest rates than is typical.  He also stated that the use of the FRB’s liquidity programs, such as the Term Auction Facility, the Primary Dealer Credit Facility and the Term Asset-Backed Securities Lending Facility, has fallen sharply and such programs have either closed or are scheduled to be phased out in the coming months.