Bernanke on QE2

As a part of his testimony before the Senate Budget Committee, Ben Bernanke made the following remark:

Conventional monetary policy works by changing market expectations for the future path of short-term interest rates, which, in turn, influences the current level of longer-term interest rates and other financial conditions. These changes in financial conditions then affect household and business spending. By contrast, securities purchases by the Federal Reserve put downward pressure directly on longer-term interest rates by reducing the stock of longer-term securities held by private investors.³  These actions affect private-sector spending through the same channels as conventional monetary policy. In particular, the Federal Reserve's earlier program of asset purchases appeared to be successful in influencing longer-term interest rates, raising the prices of equities and other assets, and improving credit conditions more broadly, thereby helping stabilize the economy and support the recovery.

In light of this experience, and with the economic outlook still unsatisfactory, late last summer the FOMC began to signal to financial markets that it was considering providing additional monetary policy accommodation by conducting further asset purchases. At its meeting in early November, the FOMC formally announced its intention to purchase an additional $600 billion in Treasury securities by the end of the second quarter of 2011, about one-third of the value of securities purchased in its earlier programs. The FOMC also maintained its policy, adopted at its August meeting, of reinvesting principal received on the Federal Reserve's holdings of securities. 

The FOMC stated that it will review its asset purchase program regularly in light of incoming information and will adjust the program as needed to meet its objectives. Importantly, the Committee remains unwaveringly committed to price stability and, in particular, to maintaining inflation at a level consistent with the Federal Reserve's mandate from the Congress.⁴ In that regard, it bears emphasizing that the Federal Reserve has all the tools it needs to ensure that it will be able to smoothly and effectively exit from this program at the appropriate time. Importantly, the Federal Reserve's ability to pay interest on reserve balances held at the Federal Reserve Banks will allow it to put upward pressure on short-term market interest rates and thus to tighten monetary policy when needed, even if bank reserves remain high. Moreover, the Fed has invested considerable effort in developing methods to drain or immobilize bank reserves as needed to facilitate the smooth withdrawal of policy accommodation when conditions warrant. If necessary, the Committee could also tighten policy by redeeming or selling securities on the open market.

Of special interest is Bernanke's interpretation of the new interest on reserves policy tool in the final paragraph. Especially interesting is that in light of all of the Fed's expanded tools throughout the recession, Bernanke chose to highlight this tool in particular as a integral part of controlling inflation throughout the recovery. Also of note is the fact that Bernanke highlights exactly the fact that I made in my previous post: given that lending picks up, the Fed plans to use its interest on reserves policy tool as a means of raising the opportunity cost for lending in order to effectively raise interest rates without forcing itself to introduce toxic assets back into financial markets.