Fed's Bernanke Says 1% Target Rate Isn't Floor, Other Actions More Effective

Federal Reserve chairman Ben Bernanke said that economic activity has downshifted further and the policy response must be vigorous. He said cutting the Fed funds target rate below 1% is "certainly feasible", but broader action could be more efficient.

"At this point, the scope for using conventional interest rate policies to support the economy is obviously limited," Bernanke said in his prepared remarks for at the Greater Austin Chamber of Commerce in Austin, Texas.

The Fed chairman said the effective rate has been trading "consistently below" the 1% target in recent weeks, reflecting the large quantity of reserves that have been injected into the system.

"In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve," Bernanke said, adding that the ability of Fannie Mae and Freddie Mac to lend money has also lowered the effective interest rate.

In addition to conventional monetary policy, Bernanke said there are "several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions."

He said the central bank could purchase longer-term Treasury or agency securities on the open market in substantial quantities, which would influence the yields on these securities and help spur aggregate demand.

"Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters," he added. "It is encouraging that the announcement of that action was met by a fall in mortgage interest rates."

The chairman also said the Fed can provide backstop liquidity directly to certain financial markets rather than just to financial institutions.

"Such programs are promising because they sidestep banks and primary dealers to provide liquidity directly to borrowers or investors in key credit markets," Bernanke said. "In this spirit, the Federal Reserve and the Treasury jointly announced last week a facility that will lend against asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration."

Bernanke said each of the approaches has the potential to improve the functioning of financial markets and to stimulate the economy.

On inflation, Bernanke said the expanding balance sheet of the Fed will have to be brought back down to normal levels once economic conditions improve. He said that will be done in a timely matter, but it is an issue for the future and need not be a concern now.

Bernanke said the government continues to "take all steps" to minimize systemic risks, and he reiterated that the Fed will "stand ready to act as needed" if economic conditions deteriorate.

Speaking briefly on the international response to the global economic slowdown, Bernanke was supportive of the "extraordinary steps to address an extraordinary situation."

By Patrick McGee and edited by Nancy Girgis
©CEP News Ltd. 2008