JACKSON HOLE, Wyo. (MNI) – The following is the fourth section of
the text of the remarks of Federal Reserve Chairman Ben Bernanke
prepared for his Jackson Hole address Friday morning:

However, the expected benefits of additional stimulus from further
expanding the Feds balance sheet would have to be weighed against
potential risks and costs. One risk of further balance sheet expansion
arises from the fact that, lacking much experience with this option, 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. The
possibility that securities purchases would be most effective at times
when they are most needed can be viewed as a positive feature of this
tool. However, uncertainty about the quantitative effect of securities
purchases increases the difficulty of calibrating and communicating
policy responses.

Another concern associated with additional securities purchases is
that substantial further expansions of the balance sheet could reduce
public confidence in the Feds 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. (Of course, if inflation expectations were too
low, or even negative, an increase in inflation expectations could
become a benefit.) To mitigate this concern, the Federal Reserve has
expended considerable effort in developing a suite of tools to ensure
that the exit from highly accommodative policies can be smoothly
accomplished when appropriate, and FOMC participants have spoken
publicly about these tools on numerous occasions. 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.

A second policy option for the FOMC would be to ease financial
conditions through its communication, for example, by modifying its
post-meeting statement. As I noted, the statement currently reflects the
FOMC’s anticipation that exceptionally low rates will be warranted “for
an extended period,” contingent on economic conditions. A step the
Committee could consider, if conditions called for it, would be to
modify the language in the statement to 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. Such a change would
presumably lower longer-term rates by an amount related to the revision
in policy expectations.

Central banks around the world have used a variety of methods to
provide future guidance on rates. For example, in April 2009, the Bank
of Canada committed to maintain a low policy rate until a specific time,
namely, the end of the second quarter of 2010, conditional on the
inflation outlook.

(In April 2010, the Bank of Canada removed the conditional
commitment from its statement, and in June 2010, the Bank raised its
policy rate and announced a return to its normal operating framework for
the overnight rate.)

Although this approach seemed to work well in Canada, committing to
keep the policy rate fixed for a specific period carries the risk that
market participants may not fully appreciate that any such commitment
must ultimately be conditional on how the economy evolves (as the Bank
of Canada was careful to state). An alternative communication strategy
is for the central bank to explicitly tie its future actions to specific
developments in the economy. For example, in March 2001, the Bank of
Japan committed to maintaining its policy rate at zero until Japanese
consumer prices stabilized or exhibited a year-on-year increase. A
potential drawback of using the FOMCs 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
Committees policy intentions with sufficient precision and
conditionality. The Committee will continue to actively review its
communication strategy, with the goal of communicating its outlook and
policy intentions as clearly as possible.

A third option for further monetary policy easing is to lower the
rate of interest that the Fed pays banks on the reserves they hold with
the Federal Reserve System. Inside the Fed this rate is known as the
IOER rate, the interest on excess reserves rate. The IOER rate,
currently set at 25 basis points, could be reduced to, say, 10 basis
points or even to zero. On the margin, a reduction in the IOER rate
would provide banks with an incentive to increase their lending to
nonfinancial borrowers or to participants in short-term money markets,
reducing short-term interest rates further and possibly leading to some
expansion in money and credit aggregates. However, under current
circumstances, the effect of reducing the IOER rate on financial
conditions in isolation would likely be relatively small. The federal
funds rate is currently averaging between 15 and 20 basis points and
would almost certainly remain positive after the reduction in the IOER
rate. Cutting the IOER rate even to zero would be unlikely therefore to
reduce the federal funds rate by more than 10 to 15 basis points. The
effect on longer-term rates would probably be even less, although that
effect would depend in part on the signal that market participants took
from the action about the likely future course of policy. Moreover, such
an action could disrupt some key financial markets and institutions.
Importantly for the Feds purposes, a further reduction in very
short-term interest rates could lead short-term money markets such as
the federal funds market to become much less liquid, as near-zero
returns might induce many participants and market-makers to exit. In
normal times the Fed relies heavily on a well-functioning federal funds
market to implement monetary policy, so we would want to be careful not
to do permanent damage to that market.

A rather different type of policy option, which has been proposed
by a number of economists, would have the Committee increase its
medium-term inflation goals above levels consistent with price
stability. I see no support for this option on the FOMC. Conceivably,
such a step might make sense in a situation in which a prolonged period
of deflation had greatly weakened the confidence of the public in the
ability of the central bank to achieve price stability, so that drastic
measures were required to shift expectations. Also, in such a situation,
higher inflation for a time, by compensating for the prior period of
deflation, could help return the price level to what was expected by
people who signed long-term contracts, such as debt contracts, before
the deflation began.

However, such a strategy is inappropriate for the United States in
current circumstances. Inflation expectations appear reasonably
well-anchored, and both inflation expectations and actual inflation
remain within a range consistent with price stability. In this context,
raising the inflation objective would likely entail much greater costs
than benefits. Inflation would be higher and probably more volatile
under such a policy, undermining confidence and the ability of firms and
households to make longer-term plans, while squandering the Feds
hard-won inflation credibility. Inflation expectations would also likely
become significantly less stable, and risk premiums in asset
markets–including inflation risk premiums–would rise. The combination
of increased uncertainty for households and businesses, higher risk
premiums in financial markets, and the potential for destabilizing
movements in commodity and currency markets would likely overwhelm any
benefits arising from this strategy.

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