This past week, Federal Reserve Chairman Ben Bernanke, publicly laid out an aggressive agenda for our central bank and suggested that he's hardly out of ammunition to fight the global financial crisis. He also gave explicit support to efforts by Congress and President-elect Barack Obama to create the largest short-term economic stimulus plan the nation's ever seen.
He cautioned, however, that any stimulus plan would be doomed if problems in the financial and credit markets aren't fixed. Bernanke outlined a number of steps that'll be taken this year to have the Fed purchase, as a buyer of last resort, the distressed assets that financial markets can't price or for which buyers can't be found.
The Fed last month dropped the federal funds rate-an overnight bank lending rate that serves as the benchmark for a wide range of consumer and business lending-to a range between zero and a quarter percent. That's the lowest it's ever been.
Interest rates are a prime tool used by the Fed to stimulate or slow the economy, depending on what's needed. A rate of effectively zero gives the impression that the Fed is now on the sidelines because it can't take rates any lower.
Not so, Bernanke said.
"Even if the overnight rate is close to zero, the committee should be able to influence longer-term interest rates by informing the public's expectations about the future course of monetary policy," he said. In other words, communicating the Fed's thinking is now more important than ever since expectations of future inflation-the rise in prices across the economy-influence investment decisions.
This comprehensive plan also includes sharply increasing the Fed's balance sheet, the listing of its financial obligations, which already has soared from $800 billion last August to more than $2.3 trillion currently.
The Fed's books already include short-term lending to banks and other financial institutions, as well as the purchase of promissory notes from U.S. corporations and mortgage bonds guaranteed by Fannie Mae and Freddie Mac.
Bernanke said that the Fed and Treasury Department next month will begin providing three-year loans to investors willing to purchase top-rated securities whose collateral is recently originated consumer and small-business loans. This move, he said, effectively substitutes a government balance sheet for private-sector balance sheets in the absence of private lending.
"If the program works as planned, it should lead to lower rates and greater availability of consumer and small-business credit," Bernanke said.
By expanding the Fed's balance sheet, he conceded, the Fed effectively is printing money, which history shows could sharply push up inflation. As the financial crisis subsides, the Fed's balance sheet will shrink, Bernanke said, and the Fed "will be able to return to its traditional means of making monetary policy _ namely, by setting a target for the federal funds rate."
When the Fed announced late last year it would purchase $600 billion of debt and mortgage bonds issued or backed by Fannie and Freddie, mortgage rates fell sharply. Now, Bernanke said, the Fed wants to purchase longer-term securities issued by the Treasury Department to lower 15-year and 30-year fixed mortgage rates, boosting the housing market.
"In determining whether to proceed with such purchases, the committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets," he said.
Implicit in that statement, however, is that interest rates may have to increase more than many Americans are accustomed to, or inflation may be higher than the Fed is comfortable with.
Neither will be pleasant choices.
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