By Steven K. Beckner

JACKSON HOLE, Wyo. (MNI) – Federal Reserve Chairman Ben Bernanke
made clear Friday that the Fed is prepared to resort to more
“unconventional” monetary stimulus, including additional purchases of
long-term securities, to avoid a “significant” further weakening of the
economy or further disinflation.

But the Fed chief said the central bank will need to carefully
evaluate whether additional quantitative easing or other measures are
needed and weigh their potential costs and benefits.

Bernanke, in a keynote address opening the Kansas City Federal
Reserve Bank’s annual symposium on “Macroeconomic Challenges: The Decade
Ahead,” explained the Federal Open Market Committee’s Aug. 10 decision
to reinvest proceeds of maturing mortgage bonds in long-term Treasury
securities.

He said it was motivated by a desire to avoid a “bad dynamic” in
which further economic slowing could lead to a further reduction in
long-term rates, which would in turn lead to further mortgage
prepayments, further shrinkage of the Fed’s balance sheet and so on in a
vicious circle that would lead to an unintended tightening of monetary
policy.

The Fed chief expressed cautious optimism that the economy will
continue to grow and even gain strength next year, and he also
considered the risks of “significant further disinflation” as well as an
“undesirable rise” in inflation to be “low.”

However, he left no doubt he and his FOMC colleagues are prepared
to act should the outlook change, and he laid out in detail what they
might be prepared to do in a lengthy policy address.

Instead of allowing maturing mortgage backed securities to run off
and gradually shrink the Fed’s bloated balance sheet, the FOMC voted
Aug. 10 to reinvest proceeds of those securities in long-term Treasuries
and to hold the balance sheet at $2.054 trillion indefinitely.

Bernanke said the move was prompted by the increase in mortgage
refinancing activity, which was causing MBS to run off “more quickly
than previously anticipated” and causing the Fed’s balance sheet to
shrink in a way that was “inconsistent with the Committee’s intention to
provide the monetary accommodation necessary to support the recovery.”

“Moreover, a bad dynamic could come into play,” he explained. “Any
further weakening of the economy that resulted in lower longer-term
interest rates and a still-faster pace of mortgage refinancing would
likely lead in turn to an even more-rapid runoff of MBS from the Fed’s
balance sheet.”

“Thus, a weakening of the economy might act indirectly to increase
the pace of passive policy tightening — a perverse outcome.”

Besides, he said, reinvesting MBS proceeds in Treasuries is “more
consistent with the Committee’s longer-term objective of a portfolio
made up principally of Treasury securities.”

But Bernanke didn’t rule out reverting to MBS purchases, saying,
“We do not rule out changing the reinvestment strategy if circumstances
warrant, however.”

By holding steady the size of the Fed’s securities portfolio,
Bernanke said the FOMC “avoided an undesirable passive tightening of
policy that might otherwise have occurred. The decision also underscored
the Committee’s intent to maintain accommodative financial conditions as
needed to support the recovery.”

And the Fed may not be done with its return to quantitative easing,
he hinted in terms stronger than those in his July 21 Monetary Policy
Report to Congress.

“We will continue to monitor economic developments closely and to
evaluate whether additional monetary easing would be beneficial,” he
said. “In particular, the Committee is prepared to provide additional
monetary accommodation through unconventional measures if it proves
necessary, especially if the outlook were to deteriorate significantly.”

Bernanke said “the issue at this stage is not whether we have the
tools to help support economic activity and guard against disinflation.
We do.”

Rather he said “the issue is instead whether, at any given
juncture, the benefits of each tool, in terms of additional stimulus,
outweigh the associated costs or risks of using the tool.”

As he did on July 21, Bernanke outlined three options the Fed has
for providing additional stimulus: expanded securities purchases,
communication changes and reducing the rate of interest the Fed pays
banks on their excess reserve balances at the Fed (IOER). And he added a
fourth option: explicitly increasing the Fed’s inflation target.

He suggested that the most likely tool the Fed would deploy is
expanded asset purchases, but not without qualification.

“I believe that additional purchases of longer-term securities,
should the FOMC choose to undertake them, would be effective in further
easing financial conditions,” he said.

“However, the expected benefits of additional stimulus from further
expanding the Fed’s balance sheet would have to be weighed against
potential risks and costs,” he added.

Bernanke said one risk of further balance sheet expansion is that
“we do not have very precise knowledge of the quantitative effect of
changes in our holdings on financial conditions.”

“In particular, the impact of securities purchases may depend to
some extent on the state of financial markets and the economy; for
example, such purchases seem likely to have their largest effects during
periods of economic and financial stress, when markets are less liquid
and term premiums are unusually high … . Uncertainty about the
quantitative effect of securities purchases increases the difficulty of
calibrating and communicating policy responses.”

Bernanke said “another concern associated with additional
securities purchases is that substantial further expansions of the
balance sheet could reduce public confidence in the Fed’s ability to
execute a smooth exit from its accommodative policies at the appropriate
time. Even if unjustified, such a reduction in confidence might lead to
an undesired increase in inflation expectations.”

But he said the Fed has sought to head off any such loss of
confidence by preparing various exit tools — reverse repurchase
agreements and so forth — for eventual use to drain reserves and
tighten policy.

“Indeed, by providing maximum clarity to the public about the
methods by which the FOMC will exit its highly accommodative policy
stance — and thereby helping to anchor inflation expectations — the
Committee increases its own flexibility to use securities purchases to
provide additional accommodation, should conditions warrant,” he said.

Bernanke said the FOMC could also change it policy guidance.
Instead of saying it expects the 0 to 25 basis point federal funds rate
to stay “exceptionally low … for an extended period,” he said the Fed
could “communicate to investors that it anticipates keeping the target
for the federal funds rate low for a longer period than is currently
priced in markets.”

Doing so “would presumably lower longer-term rates by an amount
related to the revision in policy expectations,” he said.

Alternatively, he said the Fed could follow the Bank of Canada’s
example and commit to “keep the policy rate fixed for a specific period”
or it could “explicitly tie its future actions to specific developments
in the economy” as has the Bank of Japan.

But Bernanke said “a potential drawback of using the FOMC’s
post-meeting statement to influence market expectations is that, at
least without a more comprehensive framework in place, it may be
difficult to convey the Committee’s policy intentions with sufficient
precision and conditionality.”

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