Yesterday, the House Committee on Financial Services had scheduled hearings. Bernanke had been invited. He was a no-show. Congress was shut down. So, he posted his testimony. It is here.
Before he did, the Dow was down almost 100 points. It rose to close down by only 20.
His testimony dealt with the FED’s plans for unwinding, meaning to deal with the huge increase in its portfolio, or asset base, or balance sheet: the monetary base. Until 2008, this was called high-powered money. Not any more.
The increase of over $1 trillion has been offset by the increase in banks’ excess reserves held at the FED. Most banks are not lending.
There is no need to unwind until they start lending. All the concern about unwinding has to do with the FED’s fear of mass inflation — never mentioned — if banks ever start lending.
The FED’s plans to unwind are merely hypothetical until bankers lose their fear of making loans. There is no sign of this yet.
I think their #1 fear is loan defaults by commercial real estate owners. The commercial real estate market is in the pits — the tar pits. It will get much worse over the next two years. Bankers will not be lenders until commercial real estate moves back up.
With this in mind, consider Bernanke’s testimony.
First, he praised the FED’s intervention to save the capital markets in the fall of 2008. “Great job, Ben!”
Broadly speaking, the Federal Reserve’s response to the crisis and the recession can be divided into two parts. First, our financial system during the past 2-1/2 years has experienced periods of intense panic and dysfunction, during which private short-term funding became difficult or impossible to obtain for many borrowers. The pulling back of private liquidity at times threatened the stability of major financial institutions and markets and severely disrupted normal channels of credit. In its role as liquidity provider of last resort, the Federal Reserve developed a number of programs to provide well-secured, mostly short-term credit to the financial system. These programs, which imposed no cost on the taxpayer, were a critical part of the government’s efforts to stabilize the financial system and restart the flow of credit.1 As financial conditions have improved, the Federal Reserve has substantially phased out these lending programs.
It printed digital money. The special programs are being phased out. Note: he did not say the FED will return to the conditions of August 2008. He said no more fiat money will go into these programs.
Second, after reducing short-term interest rates nearly to zero, the Federal Open Market Committee (FOMC) provided additional monetary policy stimulus through large-scale purchases of Treasury and agency securities.
How much money? About $300 billion in T-bonds, $1.25 trillion in Fannie Mae and Freddie Mac debt, and $175 billion in other agency debt.
Then he added this:
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. 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.
I repeat: “. . . at present the U.S. economy continues to require the support of highly accommodative monetary policies.” Got that? You had better get it. This was the key sentence in his testimony.
He spoke of TAF and TALF. They are going to end in March.
These two facilities will also be phased out soon: The Federal Reserve has announced that the final TAF auction will be conducted on March 8, and the TALF is scheduled to close on March 31 for loans backed by all types of collateral except newly issued commercial mortgage-backed securities (CMBS) and on June 30 for loans backed by newly issued CMBS.
So, those money spigots will be closed. But what about draining the bucket? That was what he proposed to speak about.
Will the FedFunds rate go up? No.
The FOMC anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
He keeps saying this, and we keep reading that the markets look for signs that the FED will soon raise interest rates, meaning the FedFunds rate. Before the day was over, Bloomberg ran this headline:
Bernanke Says Discount Rate May Rise ‘Before Long’ (Update3)
The discount rate is close to irrelevant. Banks rarely use the discount window. They have excess reserves. They can borrow in the federal funds overnight market at close to zero. Of all the sections of his testimony that is the least relevant to anything, it was his brief remark on the discount rate.
But, someday, over the rainbow….
In due course, however, as the expansion matures the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures. The Federal Reserve has a number of tools that will enable it to firm the stance of policy at the appropriate time.
Got that? In due course.
When that day comes, the FED can raise the rate paid on reserves. (Or not)
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.
Then he revealed his total misunderstanding of interest rates.
Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.
Longer rates will fall if the public thinks the FED is tightening. There will be a rush on T-bonds, especially long bonds. Why? Because rising short rates will create another recession. This is why the FED is trapped.