WASHINGTON (MNI) – The following is the second of three parts of
the complete text of the semi-annual monetary policy by Federal Reserve
Chairman Ben Bernanke before the Senate Banking Committee Wednesday:

Federal Reserve Policy

The Federal Reserve’s response to the financial crisis and the
recession has involved several components. First, in response to the
periods of intense illiquidity and dysfunction in financial markets that
characterized the crisis, the Federal Reserve undertook a range of
measures and set up emergency programs designed to provide liquidity to
financial institutions and markets in the form of fully secured, mostly
short-term loans. Over time, these programs helped to stem the panic and
to restore normal functioning in a number of key financial markets,
supporting the flow of credit to the economy. As financial markets
stabilized, the Federal Reserve shut down most of these programs during
the first half of this year and took steps to normalize the terms on
which it lends to depository institutions. The only such programs
currently open to provide new liquidity are the recently reestablished
dollar liquidity swap lines with major central banks that I noted
earlier. Importantly, our broad-based programs achieved their intended
purposes with no loss to taxpayers. All of the loans extended through
the multiborrower facilities that have come due have been repaid in
full, with interest. In addition, the Board does not expect the Federal
Reserve to incur a net loss on any of the secured loans provided during
the crisis to help prevent the disorderly failure of systemically
significant financial institutions.

A second major component of the Federal Reserve’s response to the
financial crisis and recession has involved both standard and less
conventional forms of monetary policy. Over the course of the crisis,
the FOMC aggressively reduced its target for the federal funds rate to a
range of 0 to 1/4 percent, which has been maintained since the end of
2008. And, as indicated in the statement released after the June
meeting, the FOMC continues to anticipate 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 addition to the very low federal funds rate, the FOMC has
provided monetary policy stimulus through large-scale purchases of
longer-term Treasury debt, federal agency debt, and agency
mortgage-backed securities (MBS). A range of evidence suggests that
these purchases helped improve conditions in mortgage markets and other
private credit markets and put downward pressure on longer-term private
borrowing rates and spreads.

Compared with the period just before the financial crisis, the
System’s portfolio of domestic securities has increased from about $800
billion to $2 trillion and has shifted from consisting of 100 percent
Treasury securities to having almost two-thirds of its investments in
agency-related securities. In addition, the average maturity of the
Treasury portfolio nearly doubled, from three and one-half years to
almost seven years. The FOMC plans to return the System’s portfolio to a
more normal size and composition over the longer term, and the Committee
has been discussing alternative approaches to accomplish that objective.

One approach is for the Committee to adjust its reinvestment policy
— that is, its policy for handling repayments of principal on the
securities — to gradually normalize the portfolio over time. Currently,
repayments of principal from agency debt and MBS are not being
reinvested, allowing the holdings of those securities to run off as the
repayments are received. By contrast, the proceeds from maturing
Treasury securities are being reinvested in new issues of Treasury
securities with similar maturities. At some point, the Committee may
want to shift its reinvestment of the proceeds from maturing Treasury
securities to shorter-term issues, so as to gradually reduce the average
maturity of our Treasury holdings toward pre-crisis levels, while
leaving the aggregate value of those holdings unchanged. At this
juncture, however, no decision to change reinvestment policy has been
made.

A second way to normalize the size and composition of the Federal
Reserve’s securities portfolio would be to sell some holdings of agency
debt and MBS. Selling agency securities, rather than simply letting them
run off, would shrink the portfolio and return it to a composition of
all Treasury securities more quickly. FOMC participants broadly agree
that sales of agency-related securities should eventually be used as
part of the strategy to normalize the portfolio. Such sales will be
implemented in accordance with a framework communicated well in advance
and will be conducted at a gradual pace. Because changes in the size and
composition of the portfolio could affect financial conditions, however,
any decisions regarding the commencement or pace of asset sales will be
made in light of the Committee’s evaluation of the outlook for
employment and inflation.

As I noted earlier, the FOMC continues to anticipate that economic
conditions are likely to warrant exceptionally low levels of the federal
funds rate for an extended period. At some point, however, the Committee
will need to begin to remove monetary policy accommodation to prevent
the buildup of inflationary pressures. When that time comes, the Federal
Reserve will act to increase short-term interest rates by raising the
interest rate it pays on reserve balances that depository institutions
hold at Federal Reserve Banks. To tighten the linkage between the
interest rate paid on reserves and other short-term market interest
rates, the Federal Reserve may also drain reserves from the banking
system. Two tools for draining reserves from the system are being
developed and tested and will be ready when needed. First, the Federal
Reserve is putting in place the capacity to conduct large reverse
repurchase agreements with an expanded set of counterparties. Second,
the Federal Reserve has tested a term deposit facility, under which
instruments similar to the certificates of deposit that banks offer
their customers will be auctioned to depository institutions.

Of course, even as the Federal Reserve continues prudent planning
for the ultimate withdrawal of extraordinary monetary policy
accommodation, we also recognize that the economic outlook remains
unusually uncertain. We will continue to carefully assess ongoing
financial and economic developments, and we remain prepared to take
further policy actions as needed to foster a return to full utilization
of our nation’s productive potential in a context of price stability

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** Market News International Washington Bureau: 202-371-2121 **

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