Federal Reserve Chairman Bernanke's written testimony provided yesterday is very important. There are three key take aways. First, investors should be prepared for a hike in the discount rate relatively soon (in what Fed-speak is "before long"). As part of the normalization of monetary policy the Fed wants to widen the spread between the Fed funds target and the discount rate, which now stands at 25 bp. A tricky thing about doing so is that it is a Federal Reserve Board decision, which means it need not take place at an FOMC meeting. Indeed by not raising the discount rate at an FOMC meeting the Fed would underscore Bernanke's point that a discount rate hike should not be seen as a policy change.

On the other hand, in the tension between the regional Fed presidents and the FRB, it might be preferable to do so at an FOMC meeting. Second, the interest rate on reserves could supplant the Fed funds rate for a time as the key policy rate. This may be coupled with some quantitative targets for excess reserves. And this ties directly to the third important point. The Fed is likely to reduce the volume of excess reserves, through tools such as reverse repos and term deposits, prior to raising rates. It will likely raise rates before selling assets. That means that these operations, especially as they increase in size, may be a revealing tell. Bernanke testimony further solidifies the understanding of the tools the Fed will use and in this sense increases transparency and arguably confidence. If he provided more insight into how the Fed will move, Bernanke gave away little in terms of when. He continued to confirm what the FOMC statement has been saying--that economic conditions are such that interest rates can remain low for an extended period.
Bernanke Bernanke Reviewed by magonomics on February 11, 2010 Rating: 5
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