Bernanke Readying His Toolbox

February 8, 2010

by The TopStock Team

One of the reasons cited for Monday’s unexpected triple-digit decline was Jon Hilsenrath’s article in the Wall Street Journal stating that Ben Bernanke is getting ready to outline the Fed’s “exit strategy.” Unlike some of his predecessors, Mr. Bernanke prefers to run a fairly transparent Fed. Thus, any mention of the steps the Fed will take to return monetary policy to normal means that the Fed may be ready to act sooner rather than later.

Given that it wasn’t long ago that Bernanke was being lambasted for keeping rates too low for too long, it isn’t terribly surprising that the Fed wants to begin reeling in some of the extreme measure it took to keep the banking system afloat during the credit crisis.

The consensus thinking has been that the Fed was not likely to increase rates at all during 2010. However, raising rates is not the only tool Bernanke and friends have in their toolbox. In fact, increasing rates may be the very last action the FOMC ultimately takes.

The first steps in the Fed’s exit plan are actually underway (and are no surprise to the markets as the plans were made public months ago). As was stated in the January 27th Press Release, the Federal Reserve will be shutting down many of the facilities it established in order to restore confidence in the system.

On February 1st, the Fed closed the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility.

While the programs have very long and confusing names, it is important to note that the Fed is in the process of winding down its Term Auction Facility as well. Other programs are slated to be wound down over the next few months. Most important among these is the “quantitative easing” Fed’s program of outright purchase of mortgage-backed securities and other bonds.

Next up, the WSJ reports that when the Fed feels the economy is healthy enough, they will begin tap the brakes a little harder. Hilsenrath notes that the Fed will do so by raising the rate paid on excess reserves. The Journal says that the centerpiece of the Fed’s plan will be a new tool Congress gave the central bank in October 2008: an interest rate the Fed pays banks on money they leave on reserve at the central bank.

If this sounds a little convoluted to you, you’re not alone. New York Fed President William Dudley explained recently, "If the [Fed] were to raise the interest rate paid on excess reserves, this would raise the price of credit. That, in turn, would limit the demand for credit."

The thinking is that the higher rate paid by the Fed would entice banks to tie up money they would normally lend out. This strategy would effectively “drain reserves” from the system and put pressure on shorter-term interest rates.

Why should you care about any of this, you ask? In short, when the Fed’s moves away from the current ultra-low interest rate environment, the maneuvers will affect everything from mortgage rates, to lines of credit, floating rate loans, and even the interest savers earn at the bank.

Given the enormity of the task at hand and the impact it will have on the credit markets, investors will want to be alert when the Fed decides to exit the easy-money highway.

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