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Written testimony from Federal Reserve Chairman Ben Bernanke released on Wednesday outlined a definite strategy for unwinding the Fed's accommodative policy but provided no timetable for when it would do so, instead saying that the central bank would be ready when the time comes.
"Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding," Bernanke said in prepared remarks.
He added, "We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively."
Though no timetable was given, Bernanke did outline specific strategies that the Fed could implement to unwind policy.
The central bank chief said that the Fed may move to a new benchmark target rate other than the federal funds rate.
In the testimony, prepared for a postponed hearing before the House Financial Services Committee, Bernanke said that the Fed may raise interest rates on reserves first, in order to put pressure on short term rates, and added that the Fed is also considering raising the discount rate in the near future.
"By increasing the interest rate on reserves, 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 markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks," he said.
He did say, though, that no decision has been made on the issue, and that the Fed would eventually return to the federal funds rate as its operating target, if it were to focus elsewhere for a time.
Bernanke also outlined other additional tools the central bank would use to reduce the reserves held by the banking system.
"Reducing the quantity of reserves will lower the net supply of funds to the money markets, which will improve the Federal Reserve's control of financial conditions by leading to a tighter relationship between the interest rate on reserves and other short-term interest rates," he said.
The Fed chair went on to say that the central bank has enhanced its ability to use reverse repurchase agreements - during which the Fed sells a security to a counterparty with an agreement to repurchase that security in the future - to absorb large quantities of reserves.
"To further increase its capacity to drain reserves through reverse repos, the Federal Reserve is also in the process of expanding the set of counterparties with which it can transact and developing the infrastructure necessary to use its MBS holdings as collateral in these transactions," Bernanke added.
The Fed chief also said that the Fed would conduct tests in the spring on using term deposits to drain reserves.
"To further increase its capacity to drain reserves through reverse repos, the Federal Reserve is also in the process of expanding the set of counterparties with which it can transact and developing the infrastructure necessary to use its MBS holdings as collateral in these transactions," Bernanke said.
He added, "Reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so." Toward the end of his testimony, Bernanke said that he did not anticipate that the Fed would sell and of its security holdings in the near term, at least until it is clear that the economy is a sustainable recovery. He added, however, that the Fed will allow agency debt and mortgage backed securities to run off as they mature or are prepaid.
Bernanke's hearing before the House Financial Services Committee was postponed due to heavy snow in Washington, D.C.
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