Fed's Bernanke: Credit easing is working

There was some good news for U.S. taxpayers and investors Friday: U.S. Federal Reserve Chairman Ben Bernanke said the Fed's credit easing program is working and the central bank expects to be repaid for its interventions to save AIG (AIG) and to facilitate the acquisition of Bear Stearns by JPMorgan Chase (JPM).

"From a credit perspective, these support facilities carry more risk than traditional central bank liquidity support, but we nevertheless expect to be fully repaid," Bernanke said in a Friday afternoon speech delivered at the Federal Reserve Bank of Richmond's 2009 Credit Markets Symposium.

Fed can unwind programs quickly

Bernanke also said credit programs implemented "can be unwound quickly as markets and the economy revive," and also reiterated the central bank's view -- held by many Congressional leaders and by U.S. Treasury Secretary Tim Geithner -- that there is a need to create a new federal regulatory body to prevent the chaotic failure of key institutions, such as the Lehman Brothers failure, and to define the Fed's role in such a plan. Bernanke did not, however, indicate or suggest exactly he thought that role should be.

Since the financial crisis began, the Fed's balance sheet has more than doubled, from $870 billion to about $2 trillion.

Addresses money supply

One pressing issue for some investors concerns the risk that funds added to the money supply will increase U.S. inflation, but Bernanke underscored that the Fed is thoroughly monitoring prices and wages and has several tools to contain inflation, should it re-ignite.

"We have a number of tools we can use to reduce bank reserves or increase short-term interest rates when that becomes necessary," Bernanke said. These include: 1) short-term credit unwinding, 2) reverse purchase agreements to drain banks of reserves, 3) soak reserves up via the U.S. Treasury's Supplementary Financing Program, and 4) raising interest rates that the Fed pays banks for holding bank reserves, which would reduce bank lending.

Bernanke added that the Fed and the Treasury also have agreed to seek legislation to provide additional tools for managing bank reserves.

Fiscal Policy Analysis: Fed Chair Bernanke did a good job Friday outlining the Fed's credit unwinding flexibility, after the U.S. economy starts to recover, and at allaying fears about inflation-fighting capabilities.

What Bernanke did not elaborate on -- and this, one should underscore, is not an easy question to answer -- is how would the Fed respond in the event the recession worsens, with a commensurate rise in the unemployment rate, amid a rise in inflation? Would the Fed tolerate slightly higher inflation rate to achieve much-needed employment gains? Would it delay unwinding various credit programs in the hopes of increasing growth further, even amid higher inflation?

Or, even though it has a dual mandate of price stability and full employment, would the Fed do what economist Richard Felson predicts should job growth be insufficient: concentrate on lowering inflation, and leave the problem of high unemployment to the Congress and fiscal policy?

Bernanke gave absolutely no hint on Friday, but in his defense, it's difficult to press him on the issue, as it would represent uncharted waters for a Fed chief: The United States has never faced a condition involving 10 percent unemployment and rising inflation. Personally, I don't think we will this time either.
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