Bernanke Says Discount Rate May Rise ‘Before Long’

By Scott Lanman and Craig Torres

Feb. 10 (Bloomberg) -- The Federal Reserve may raise the discount rate “before long” as part of the “normalization” of Fed lending, a move that won’t signal any change in the outlook for monetary policy, Chairman Ben S. Bernanke said.

Bernanke repeated the Federal Open Market Committee statement that low rates are warranted “for an extended period” in testimony prepared for the House Financial Services Committee. The Fed may also temporarily replace the federal funds rate as a policy guide with interest it pays on banks’ deposits should fed funds become a “less reliable indicator than usual,” Bernanke said.

Bernanke, who this month started his second four-year term as Fed chief, previewed what would be the first interest-rate move in more than a year while giving more details on several tools that may be used to tighten credit “at some point.” Bernanke, 56, and his fellow policy makers are preparing to remove unprecedented monetary stimulus as the U.S. economy is forecast to grow at the fastest pace since 2006.

“Before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate,” Bernanke said in the testimony for a hearing originally scheduled for today and postponed because of a snowstorm. A new date hasn’t been announced.

Two-year Treasury securities fell, pushing the yield to 0.84 percent at 10:07 a.m. in New York from 0.83 percent yesterday. U.S. stocks extended declines, with the Standard & Poor’s 500 Index falling 0.5 percent to 1,064.77. The dollar extended gains against the euro.

Outlook for Policy

The changes “are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about as it was at the time of the January meeting of the FOMC,” Bernanke said.

In December 2008, the Fed cut the discount rate, charged on direct loans to commercial banks, to 0.5 percent as it lowered the separate federal funds rate, which banks use for overnight loans to each other, to a range of zero to 0.25 percent. Both rates have been unchanged since then.

“Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding,” Bernanke said.

Lending Freeze

Before August 2007, the discount rate was set at one percentage point above the federal funds rate. As bank lending began to freeze that month, the Fed reduced the difference to a half-point and narrowed it again, to a quarter-point, in March 2008 in conjunction with its rescue of Bear Stearns Cos.

The central bank has already reduced the maximum term of discount-window loans to banks to 28 days from 90 days, “and we will consider whether further reductions in the maximum loan maturity are warranted,” Bernanke said.

The Fed incurred no losses on its $1.5 trillion of emergency lending programs, and the Board of Governors “continues to anticipate” it will not lose money on the bailouts of Bear Stearns and New-York based insurer American International Group Inc. The Fed’s portion of those rescues totals about $116 billion, Bernanke said.

The Fed’s unprecedented actions under Bernanke have helped thaw credit markets.

The Libor-OIS spread, a gauge of banks’ willingness to lend, has narrowed to 0.10 percentage point from a record 3.64 points in October 2008. The TED spread, the difference between what the Treasury and banks pay to borrow dollars for three months, has narrowed to 0.15 percentage point from as high as 4.64 percentage points in October 2008.

Deposits at Fed

Separately, Bernanke said raising the interest rate paid on funds deposited by banks at the Fed, as well as so-called reverse repurchase agreements that temporarily drain cash from the banking system, will probably be the first tools for tightening credit.

Bernanke said he doesn’t expect the Fed “in the near term” to sell the $1.43 trillion of housing debt being purchased through next month, “at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery.” Fed officials may decide “in the future” to sell securities, he said.

“Any such sales would be at a gradual pace, would be clearly communicated to market participants and would entail appropriate consideration of economic conditions,” Bernanke said.

The purchases have helped push total assets on the Fed’s balance sheet to $2.25 trillion from $925 billion at the start of 2008. Excess reserves in the banking system total more than $1 trillion.

Removing Reserves

The central bank can use several tools to temporarily remove those reserves from the financial system and thereby raise the federal funds rate. Bernanke said the Fed is expanding the set of counterparties for reverse repurchase agreements, under which it provides securities as collateral in exchange for a short-term cash loan.

Bernanke said “one possible sequence” of the exit strategy involves first testing tools for draining reserves “on a limited basis.” Then, “as the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates,” he said.

‘Firming’ of Policy

The Fed would then execute the “actual firming of policy” by raising the interest rate on bank reserves, Bernanke said. Congress granted the Fed the power in October 2008 as part of the law creating the $700 billion Troubled Asset Relief Program.

While Fed officials have previously said the deposit rate will play a major role in the exit strategy, Bernanke said the rate may replace the federal funds rate, the policy benchmark for the past two decades, until reserves are “much lower.”

“It is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates,” Bernanke said.

The Fed may be months away from tightening credit. U.S. central bankers will begin raising rates in November and increase the benchmark lending rate to 0.75 percent by the end of the year, according to the median estimate of economists surveyed by Bloomberg News in January.

The U.S. economy will expand 2.7 percent this year, according to the median estimate. The timing and speed of rate increases may also depend on how quickly the economy can begin to generate job growth.

“It is great that he is laying out a blueprint. It will reduce market uncertainty,” said Karl Haeling, head of strategic debt distribution at Landesbank Baden-Wuerttemberg, Germany’s third-largest bank, before the release of the testimony.