Bernanke Says Fed ‘Confident’ of Ability to Stem Inflation

By Scott Lanman

July 21 (Bloomberg) -- The U.S. Federal Reserve is “confident” of its ability to stem inflation after what’s likely to be an “extended period” for policies aimed at restarting lending, Chairman Ben S. Bernanke said.

“When the economic outlook requires us to do so,” the central bank will employ a series of tools to tighten policy, Bernanke said, writing in an opinion piece in the Wall Street Journal.

Bernanke outlined five ways the central bank will be able to prevent the record reserves that banks have accumulated from causing money supply and inflation to surge. Officials will use the interest rate on banks’ deposits with the Fed as a principal tool, which they can supplement with other means, including reverse-repurchase agreements and term deposits, he said.

The opinion piece, published late yesterday, before Bernanke’s semiannual monetary-policy testimony to Congress today, signals he’s seeking to reassure investors that the Fed will contain consumer prices when the economy recovers.

“Bernanke is preparing the market by communicating at an early stage,” said Seiji Shiraishi, chief economist for Japan at HSBC Securities Japan Ltd. in Tokyo. “Whether they can do that will depend on the strength of the cyclical recovery and the soundness of the banks.”

The 10-year note yield fell three basis points to 3.58 percent at 12:53 p.m. in Tokyo, according to data compiled by Bloomberg.

‘Top Priority’

The Fed said in minutes of last month’s policy meeting that making sure it has the ability to tighten credit at some point is a “top priority.” Officials discussed their options at the session, even as most policy makers judged the economy at risk to further shocks, the minutes showed last week.

“We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner,” Bernanke said in the opinion article.

Since March 2008, the Fed has taken steps to combat the credit crisis that included expanded emergency lending to banks, support for the commercial-paper market and a lifeline to insurer American International Group Inc. Total assets on the Fed’s balance sheet now stand at $2.07 trillion, up $1.16 trillion over the past year. The central bank has also cut the benchmark lending rate to a range of zero to 0.25 percent.

Need for Strategy

Without an exit strategy, the increase in bank reserves could cause inflation because banks would be able to lend on the money, potentially fueling a surge in money growth. The Fed, then, must either shrink the amount of reserves or find a way to keep banks from lending them for bigger yields.

“We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability,” Bernanke said.

To keep interest rates low and credit flowing to housing markets, the Fed plans this year to buy as much as $1.75 trillion of mortgage-backed securities, housing-agency debt and Treasuries. The last exit option, “if necessary,” would be to sell some of the securities on the open market, Bernanke said.

In a term reverse-repurchase agreement, the central bank would enter into a longer-term contract to sell securities to primary dealers, in effect removing money from the banking system temporarily, and repurchase them at a later date.

Term Deposits

The Fed’s proposed term deposits would be similar to banks’ certificates of deposit for customers, and funds held at the Fed would not be available to lend in the overnight federal funds market, Bernanke said.

Another option would be for the Treasury to sell bills and deposit the funds with the Fed, Bernanke wrote.

“Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury,” the Fed chief said.

The Fed received legislative authority to begin paying interest on reserves in October as part of legislation creating the $700 billion financial-rescue fund.

Fed officials hoped that would help keep the benchmark interest rate stable while the central bank flooded the banking system with cash. The authority failed to keep the main federal- funds rate from declining almost to zero before the Fed officially lowered it that far. The Fed currently pays 0.25 percent on required and excess reserve balances.

Banks’ deposits with the Fed increased to $772 billion in June from $9.3 billion a year earlier.

Bernanke said the deposit rate will work better “under more normal financial conditions” and limit the gap between that and the federal funds rate. “If that gap persists,” the Fed will use the other tools, he said.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net.