• The timing of the exit strategy will be determined to economic and financial developments
  • Economic slack, subdued inflation trends and stable inflation expectations support maintaining low rates for a prolonged period
  • The Fed remains committed to transparency, but will ensure that monetary policy remains insulated from political pressures

Bernanke reinforced the message that rates will stay low for an extended period in today’s semiannual report to Congress. While his comments on the economic outlook acknowledged the improvement in the economy and financial markets over the second half of 2009, he declared that, “a sustainable recovery will depend on continued growth in private-sector final demand for goods and services.” Positive indications are the recent pick-up in consumer demand, business investment in equipment and software and international trade, but concerns lie in housing starts, which have flattened in recent months, and the ongoing decline of commercial real estate. Bernanke also highlighted particular risks in the labor market due to the rise in longterm unemployment.

Bernanke’s message on the exit strategy also remained the same as previous communications. He reiterated that “the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments.” In addition, he gave further indications that the primary policy tool will be to raise the interest rate on reserves so that “the Federal Reserve will be able to put significant upward pressure on all short-term interest rates.” Additional tools will be reverse repos, term deposits and redeeming or selling securities. Furthermore, he restated that last week’s decision to raise the discount rate was to normalize lending to commercial banks and will not affect interest rates to consumers or businesses.

The final sections of the testimony focused on transparency and regulatory reform. While the Fed agreed to a GAO audit of the special credit and liquidity lending facilities and agreed to work with Congress to enhance transparency, Bernanke stated that, “it is vital that the conduct of monetary policy continue to be insulated from short-term political pressures so that the FOMC can make policy decisions in the longer-term economic interests of the American people.” Lastly, Bernanke emphasized the importance of financial reform, highlighting the Fed’s efforts to improve its own regulatory processes and its commitment to consumer protection regulation.

Bottom-line: Bernanke’s overall message was consistent with previous Fed communications and recent speeches. While Bernanke has not yet announced a concrete exit strategy, we expect the Fed to remain communicative and transparent in its plans. Furthermore, it will continue to promote regulatory reform of the financial system. The Fed’s outlook remains consistent with our baseline scenario of moderate growth in final demand in 2010. Accordingly, we maintain our forecast that the target rate will remain low for a prolonged period.