Ben S Bernanke: Federal Reserve's exit strategy
Testimony by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal
Reserve System, before the Committee on Financial Services, US House of
Representatives, Washington DC, 10 February 2010.
Statement as prepared for delivery. The hearing was postponed due to inclement weather.
* * *
Chairmen Frank and Watt, Ranking Members Bachus and Paul, and other members of the
Committee and Subcommittee, I appreciate the opportunity to discuss the Federal Reserve's
strategy for exiting from the extraordinary lending and monetary policies that it implemented
to combat the financial crisis and support economic activity.
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
shortterm 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.
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. These asset purchases, which had the
additional effect of substantially increasing the reserves that depository institutions hold with
the Federal Reserve Banks, have helped lower interest rates and spreads in the mortgage
market and other key credit markets, thereby promoting economic growth. 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.
Liquidity programs
With the onset of the crisis in the late summer and fall of 2007, the Federal Reserve aimed to
ensure that sound financial institutions had sufficient access to short-term credit to remain
sufficiently liquid and able to lend to creditworthy customers, even as private sources of
liquidity began to dry up. To improve the access of banks to backup liquidity, the Federal
Reserve reduced the spread over the target federal funds rate of the discount rate - the rate
at which the Fed lends to depository institutions through its discount window - from
100 basis points to 25 basis points, and extended the maximum maturity of discount window
loans, which had generally been limited to overnight, to 90 days.
Many banks, however, were evidently concerned that if they borrowed from the discount
window, and that fact somehow became known to market participants, they would be
perceived as weak and, consequently, might come under further pressure from creditors. To
address this so-called stigma problem, the Federal Reserve created a new discount window
program, the Term Auction Facility (TAF). Under the TAF, the Federal Reserve has regularly
auctioned large blocks of credit to depository institutions. For various reasons, including the
competitive format of the auctions, the TAF has not suffered the stigma of conventional
discount window lending and has proved effective for injecting liquidity into the financial
system.2
Liquidity pressures in financial markets were not limited to the United States, and intense
strains in the global dollar funding markets began to spill over to U.S. markets. In response,
the Federal Reserve entered into temporary currency swap agreements with major foreign
central banks. Under these agreements, the Federal Reserve provided dollars to foreign
central banks in exchange for an equally valued quantity of foreign currency; the foreign
central banks, in turn, lent the dollars to banks in their own jurisdictions. The swaps helped
reduce stresses in global dollar funding markets, which in turn helped to stabilize
U.S. markets. Importantly, the swaps were structured so that the Federal Reserve bore no
foreign exchange risk or credit risk.3
As the financial crisis spread, the continuing pullback of private funding contributed to the
illiquid and even chaotic conditions in financial markets and prompted runs on various types
of financial institutions, including primary dealers and money market mutual funds.4 To arrest
these runs and help stabilize the broader financial system, the Federal Reserve used its
emergency lending authority under Section 13(3) of the Federal Reserve Act - an authority
not used since the Great Depression - to provide short-term backup funding to certain
nondepository institutions through a number of temporary facilities.5 For example, in March
2008 the Federal Reserve created the Primary Dealer Credit Facility, which lent to primary
dealers on an overnight, overcollateralized basis. Subsequently, the Federal Reserve
created facilities that proved effective in helping to stabilize other key institutions and
markets, including money market mutual funds, the commercial paper market, and the
assetbacked securities market.
As was intended, use of many of the Federal Reserve's lending facilities has declined
sharply as financial conditions have improved.6 Some facilities were closed over the course
of 2009, and most other facilities expired at the beginning of this month. As of today, the only
facilities still in operation that offer credit to multiple institutions, other than the regular
discount window, are the TAF (the auction facility for depository institutions) and the Term
Asset-Backed Securities Loan Facility (TALF), which has supported the market for asset-
2
Another possible reason that the TAF has not suffered from stigma is that auctions are not settled for several
days, which signals to the market that auction participants do not face an immediate shortage of funds.
3
In particular, foreign central banks, not the Federal Reserve, bore the credit risk associated with the foreign
central banks' dollar-denominated loans to financial institutions.
4
Primary dealers are broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of
New York.
5
Section 13(3) of the Federal Reserve Act authorizes Reserve Banks to lend to individuals, partnerships, and
corporations in "unusual and exigent circumstances" as determined by the Board of Governors. The Federal
Reserve invoked Section 13(3) on two occasions during the 1960s to establish lending facilities for savings
associations; however, no credit was extended through either facility.
6
In designing its facilities, the Federal Reserve in many cases incorporated features - such as pricing that was
unattractive under normal financial conditions - aimed at encouraging borrowers to reduce their use of the
facilities as financial conditions returned to normal. In the case of other facilities, particularly those that made
available fixed amounts of credit through auctions, the Federal Reserve has gradually reduced offered
amounts.
BIS Review 15/2010
backed securities, such as those that are backed by auto loans, credit card loans, small
business loans, and student loans. 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.7
In addition, the Federal Reserve is in the process of normalizing the terms of regular discount
window loans. We have reduced the maximum maturity of discount window loans to 28 days,
from 90 days, and we will consider whether further reductions in the maximum loan maturity
are warranted. Also, before long, we expect to consider a modest increase in the spread
between the discount rate and the target federal funds rate. These changes, like the closure
of a number of lending facilities earlier this month, should be viewed as further normalization
of the Federal Reserve's lending facilities, in light of the improving conditions in financial
markets; they are not expected to lead to tighter financial conditions for households and
businesses and should not be interpreted as signaling any change in the outlook for
monetary policy, which remains about as it was at the time of the January meeting of the
FOMC.
In summary, to help stabilize financial markets and to mitigate the effects of the crisis on the
economy, the Federal Reserve established a number of temporary lending programs. Under
nearly all of the programs, only short-term credit, with maturities of 90 days or less, was
extended, and under all of the programs credit was overcollateralized or otherwise secured
as required by law. The Federal Reserve believes that these programs were effective in
supporting the functioning of financial markets and in helping to promote a resumption of
economic growth. The Federal Reserve has borne no loss on these operations thus far and
anticipates no loss in the future. The exit from these programs is substantially complete:
Total credit outstanding under all programs, including the regular discount window, has fallen
sharply from a peak of $1-1/2 trillion around year-end 2008 to about $110 billion last week.
Separately, to prevent potentially catastrophic effects on the U.S. financial system and
economy, and with the support of the Treasury Department, the Federal Reserve also used
its emergency lending powers to help avoid the disorderly failure of two systemically
important financial institutions, Bear Stearns and American International Group. Credit
extended under these arrangements currently totals about $116 billion, or about 5 percent of
the Federal Reserve's balance sheet. The Federal Reserve expects these exposures to
decline gradually over time. The Board continues to anticipate that the Federal Reserve will
ultimately incur no loss on these loans as well. These loans were made with great reluctance
under extreme conditions and in the absence of an appropriate alternative legal framework.
To preclude any future need for the Federal Reserve to lend in similar circumstances, we
strongly support the establishment of a statutory regime for the safe resolution of failing,
systemically important nonbank financial institutions.
Monetary policy and asset purchases
In addition to supporting the functioning of financial markets, the Federal Reserve also
applied an extraordinary degree of monetary policy stimulus to help counter the adverse
effects of the financial crisis on the economy. In September 2007, the Federal Reserve
began reducing its target for the federal funds rate from an initial level of 5-1/4 percent. By
late 2008, this target reached a range of 0 to 1/4 percent, essentially the lowest feasible
level. With its conventional policy arsenal exhausted and the economy remaining under
severe stress, the Federal Reserve decided to provide additional stimulus through
largescale purchases of federal agency debt and mortgage-backed securities (MBS) that are fully
guaranteed by federal agencies. In March 2009, the Federal Reserve expanded its
purchases of agency securities and began to purchase longer-term Treasury securities as
well. All told, the Federal Reserve purchased $300 billion of Treasury securities and currently
anticipates concluding purchases of $1.25 trillion of agency MBS and about $175 billion of
agency debt securities at the end of March. The Federal Reserve's purchases have had the
effect of leaving the banking system in a highly liquid condition, with U.S. banks now holding
more than $1.1 trillion of reserves with Federal Reserve Banks. A range of evidence
suggests that these purchases and the associated creation of bank reserves have helped
improve conditions in private credit markets and put downward pressure on longer-term
private borrowing rates and spreads.
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. 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.
Most importantly, in October 2008 the Congress gave the Federal Reserve statutory
authority to pay interest on banks' holdings of reserve balances. 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. 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.8
The Federal Reserve has also been developing a number of additional tools it will be able to
use to reduce the large quantity of 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.
One such tool is reverse repurchase agreements (reverse repos), a method that the Federal
Reserve has used historically as a means of absorbing reserves from the banking system. In
a reverse repo, the Federal Reserve sells a security to a counterparty with an agreement to
repurchase the security at some date in the future. The counterparty's payment to the
Federal Reserve has the effect of draining an equal quantity of reserves from the banking
system. Recently, by developing the capacity to conduct such transactions in the triparty
repo market, the Federal Reserve has enhanced its ability to use reverse repos to absorb
very large quantities of reserves. The capability to carry out these transactions with primary
dealers, using our 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
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.
As a second means of draining reserves, the Federal Reserve is also developing plans to
offer to depository institutions term deposits, which are roughly analogous to certificates of
deposit that the institutions offer to their customers. The Federal Reserve would likely auction
large blocks of such deposits, thus converting a portion of depository institutions' reserve
balances into deposits that could not be used to meet their very short-term liquidity needs
and could not be counted as reserves. A proposal describing a term deposit facility was
Federal
recently published in the Register, and we are currently analyzing the public
comments that have been received. After a revised proposal is reviewed by the Board, we
expect to be able to conduct test transactions this spring and to have the facility available if
necessary shortly thereafter. 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.
The Federal Reserve also has the option of redeeming or selling securities as a means of
applying monetary restraint. A reduction in securities holdings would have the effect of
further reducing the quantity of reserves in the banking system as well as reducing the
overall size of the Federal Reserve's balance sheet.
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. One possible sequence would involve the Federal Reserve
continuing to test its tools for draining reserves on a limited basis, in order to further ensure
preparedness and to give market participants a period of time to become familiar with their
operation. 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. The actual firming of policy would then be implemented
through an increase in the interest rate paid on reserves. If economic and financial
developments were to require a more rapid exit from the current highly accommodative
policy, however, the Federal Reserve could increase the interest rate paid on reserves at
about the same time it commences significant draining operations.
I currently do not anticipate that the Federal Reserve will sell any of its security holdings in
the near term, at least until after policy tightening has gotten under way and the economy is
clearly in a sustainable recovery. However, to help reduce the size of our balance sheet and
the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or
are prepaid. The Federal Reserve is currently rolling over all maturing Treasury securities,
but in the future it may choose not to do so in all cases. In the long run, the Federal Reserve
anticipates that its balance sheet will shrink toward more historically normal levels and that
most or all of its security holdings will be Treasury securities. Although passively redeeming
agency debt and MBS as they mature or are prepaid will move us in that direction, the
Federal Reserve may also choose to sell securities in the future when the economic recovery
is sufficiently advanced and the FOMC has determined that the associated financial
tightening is warranted. Any such sales would be at a gradual pace, would be clearly
communicated to market participants, and would entail appropriate consideration of
economic conditions.
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. Accordingly, the Federal Reserve is considering the
utility, during the transition to a more normal policy configuration, of communicating the
stance of policy in terms of another operating target, such as an alternative short-term
interest rate. In particular, it is possible that the Federal Reserve could for a time use the
interest rate paid on reserves, in combination with targets for reserve quantities, as a guide
to its policy stance, while simultaneously monitoring a range of market rates. No decision has
been made on this issue; we will be guided in part by the evolution of the federal funds
market as policy accommodation is withdrawn. The Federal Reserve anticipates that it will
eventually return to an operating framework with much lower reserve balances than at
present and with the federal funds rate as the operating target for policy.9
Conclusion
To sum up, in response to severe threats to our economy, the Federal Reserve created a
series of special lending facilities to stabilize the financial system and encourage the
resumption of private credit flows. As market conditions and the economic outlook have
improved, many of these programs have been terminated or are being phased out. The
Federal Reserve also promoted economic recovery through sharp reductions in its target for
the federal funds rate and through purchases of securities. The economy continues to
require the support of accommodative monetary policies. However, we have been working to
ensure that we have the tools to reverse, at the appropriate time, the currently very high
degree of monetary stimulus. We have full confidence that, when the time comes, we will be
ready to do so.