• The interest rate on reserves could replace the fed funds rate as the primary monetary policy tool until conditions normalize
  • The timeline will be dictated by economic and financial developments

Bernanke outlined the tools available to the Federal Reserve to manage interest rates and reduce the large quantity of reserves held by the banking system in a testimony before the House Committee on Financial Services.

Bernanke addressed the possibility of communicating monetary policy through the interest rate paid on reserves, rather than the federal funds rate, an idea that has been mentioned in recent speeches by Fed officials. “As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets.” Given current conditions, utilizing the interest rate on reserves as the primary policy tool could lend the Fed greater control over interest rates, instill confidence in the markets and anchor inflation expectations.

Bernanke highlighted two of the Federal Reserve’s other tools. The first is the reverse repo. With this product, the Fed will sell a security to a counterparty with the agreement to repurchase it on a given date. The counterparty’s payment will effectively reduce their level of reserves. Reverse repos often have short maturities and could serve as flexible solutions on an as needed basis. In fact, the product has already been tested by the Fed and is currently available. Another option is the term deposit, which would have a longer maturity and work by turn “a portion of depository institutions’ reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves.” While Bernanke described the exit tools, he did not specify an exact timeline, a move that will give the Fed flexibility. The strategy and pace will be defined by economic and financial developments.

Bottom-line: Bernanke’s speech did not introduce any new tools or concepts, but it gave detail about how they will work and what they will target, which will instill confidence in the market. Uncertainty still remains around exactly when the Fed will begin to reduce liquidity on a larger-scale basis, but Bernanke sent the message that it has the means necessary when the time comes. Furthermore, while the tools are new to the Federal Reserve, they have been used effectively by other central banks around the world. The Fed’s strategy is expected to be gradual in the near-term, with a primary focus on reducing liquidity followed by an increase in the federal funds rate.