Fed signals interest rate increase

The US Federal Reserve takes first steps to wind down unprecedented stimulus measures by signalling both the need to remove some cash from the financial system and raising short-term interest rates.

The US Federal Reserve yesterday took the first steps to wind down unprecedented stimulus measures by signalling both the need to remove some cash from the financial system and raising short-term interest rates. But the Fed chairman Ben Bernanke repeated the federal open market committee statement that low rates were warranted "for an extended period" in testimony prepared for the House financial services committee.

Mr Bernanke, who this month started his second four-year term as chairman, previewed what would be the first interest rate move in more than a year while giving more details on several tools that may be used to tighten credit "at some point". "Before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate," he said in the testimony for a hearing originally scheduled for yesterday and postponed because of a snowstorm. A new date has not been announced.

In December 2008, the Fed cut the discount rate charged on direct loans to commercial banks to 0.5 per cent as it lowered the separate federal funds rate, which banks use for overnight loans to each other, to a range of between zero and 0.25 per cent. Both rates have been unchanged since then. "Although at present the US economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding," Mr Bernanke said.

Before August 2007, the discount rate was set at 1 percentage point above the federal funds rate. As bank lending began to freeze that month, the Fed reduced the difference to a half-point and narrowed it again to a quarter of a point in March 2008, in conjunction with its rescue of Bear Stearns. The central bank has already reduced the maximum term of discount-window loans to banks to 28 days from 90 days, "and we will consider whether further reductions in the maximum loan maturity are warranted", Mr Bernanke said.

The Fed incurred no losses on its US$1.5 trillion (Dh5.51tn) of emergency lending programmes, and the board of governors "continues to anticipate" it will not lose money on the bailouts of Bear Stearns and the New York-based insurer American International Group. The Fed's portion of those rescues totalled about $116 billion, Mr Bernanke said. The Fed's unprecedented actions under Mr Bernanke have helped thaw credit markets. The Libor-OIS spread, a gauge of banks' willingness to lend, has narrowed to 0.10 percentage point from a record 3.64 points in October 2008.

The TED spread, the difference between what the Treasury and banks pay to borrow dollars for three months, has narrowed to 0.15 of a percentage point from as high as 4.64 percentage points in October 2008. Separately, Mr Bernanke said raising the interest rate paid on funds deposited by banks at the Fed, as well as so-called reverse repurchase agreements that temporarily drain cash from the banking system, would probably be the first tools for tightening credit.

He said he did not expect the Fed "in the near term" to sell the $1.43tn of housing debt being purchased through next month "at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery". Fed officials may decide "in the future" to sell securities, he said. "Any such sales would be at a gradual pace, would be clearly communicated to market participants and would entail appropriate consideration of economic conditions."

The purchases have helped push total assets on the Fed's balance sheet to $2.25tn from $925bn at the start of 2008. Excess reserves in the banking system total more than $1tn. * with Bloomberg