Bernanke Testifies in Biannual Policy Meeting

In anticipation of Federal Reserve chairman Ben Bernanke’s biannual testimony to Congress, markets are poised to begin the Tuesday session looking up. The bondholder rescue of CIT Group has also boosted sentiment, and yesterday’s upgraded forecast from Goldman Sachs on the S&P 500 hasn’t hurt either.

The main event today is Bernanke’s testimony at 10 am. Stealing his own thunder, however, Bernanke hit on all the key themes in an op-ed published in the Wall Street Journal this morning. The Chairman said the central bank has all the tools it needs to tighten monetary policy when the economy improves, but, crucially, he said that conditions won’t warrant a tighter policy for an “extended period.”

Bernanke Confronted ‘Exit Strategy’ Concerns Head On: “…as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road…. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner….When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.”

Don’t Expect Policy to be Tightened Soon: “…the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period.”

Bernanke's strategy takes four steps. First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants … Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve … Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers (a.k.a. the Fed selling debt although it will be called a CD instead of a bill or CP)… Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Analysts at BMO Capital Markets point out that asset stales are the fourth step, meaning that the Fed “wants to minimize the impact of its liquidity removal on term rates.” 

Reacting to Bernanke’s Op-Ed piece, Lloyds TSB Corporate Markets economist Kenneth Broux said: “Suspense is gone and speculation quelled that the Fed is planning to exit quantitative easing soon.”

No major data is scheduled for the rest of the day, but markets will still be glued to the Q&A with Ben Bernanke on Capitol Hill, which begins on the House today and continues in the Senate tomorrow.

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