The Federal Reserve will take a new approach to setting US interest rates as it begins to tighten monetary policy in response to an economic recovery.
The central bank's chairman, Ben Bernanke, acknowledged yesterday that traditional tools for manipulating interest rates may not be effective since hundreds of billions of dollars in extra liquidity was pumped in to prevent the financial system from collapse during the credit crisis.
His remarks, prepared for a hearing on Capitol Hill on the Fed's "exit strategy" from more than two years of emergency measures, suggest that the central bank's regular statements on monetary policy could look very different in the future.
There is so much money sloshing through financial markets that it is harder for the central bank to be sure that raising one particular interest rate will have a big effect on all the other rates on which the economy relies, from short-term lending between banks to the rates charged on mortgages, credit cards and commercial loans.
Instead of setting a target for a key short-term market interest rate, called the federal funds rate, the Fed could instead set a target for the amount of reserves held with the central bank. The amount of reserves that US banks hold at the Fed has ballooned to $1.1 trillion because the central bank has printed money to lend out into the system. Since October 2008, the Fed has had the authority to pay interest on those reserves – currently 0.25 per cent – and that rate could become more important than the fed funds rate, at least in the short term.
The fed funds target was cut to zero-0.25 per cent in December 2008, the lowest possible. The Fed also resorted to quantitative easing to stimulate the economy, using newly printed money to buy Treasuries and mortgage-backed securities, which helped reduce bank interest rates across the economy.
In addition, as markets collapsed, the Fed invented a dizzying array of technical processes for putting new lending into the system, and Mr Bernanke testified that officials had already invented several new processes for doing the opposite, including auctioning new "term deposits" which would tie up bank cash for set periods of time.
"The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments," he said, and he suggested the Fed would experiment with various different operations.
The Fed would be able to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so, Mr Bernanke told lawmakers. The actual tightening of monetary policy could then be implemented through an increase in the interest rate paid on reserves.
Mr Bernanke did not appear in person, since most business on Capitol Hill has been postponed due to snow, but he took the opportunity in his written statement to reiterate that monetary policy would remain exceptionally loose for some time still, while the economy is still fragile.
US trade deficit figures out yesterday underscored the slow healing of global trade: the value of both imports and exports rose and the US trade gap with the rest of the world widened to $40.2bn in December, its largest in a year and up from $36.4bn in November.Reuse content