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Bernanke outlines strategy to reel in stimulus measures

Deciding when and how to remove all the stimulus aid is the biggest challenge for Federal Reserve chief Ben Bernanke. Deciding when and how to remove all the stimulus aid is the biggest challenge for Federal Reserve chief Ben Bernanke.
By Jeannine Aversa
Associated Press / February 11, 2010

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WASHINGTON - Federal Reserve chairman Ben Bernanke began yesterday to outline the central bank’s strategy for reeling in stimulus money once the economic recovery is more firmly rooted.

Bernanke said the Fed will likely start to tighten credit by boosting the interest rate it pays banks on money they leave at the central bank. Doing so would raise rates tied to commercial banks’ prime rate and affect many consumer loans. Companies and ordinary Americans would pay more to borrow.

Bernanke’s remarks on the Fed’s eventual pullback of economic aid come amid signs that the global recovery remains fragile. Europe is trying to contain a debt crisis. And President Obama is pushing for tax breaks to generate jobs.

But in his prepared remarks to a House committee, Bernanke indicated the Fed is still months away from raising rates or draining most of the stimulus money it injected to rescue the financial system. He said the recovery still needs support from record-low interest rates.

The Fed chief used his remarks to explain how the central bank will try to withdraw the stimulus money without tipping the economy back into recession.

Using the rate it pays on banks’ excess reserves to affect credit would be a new strategy for the Fed. Since the 1980s, its main lever to tighten or loosen credit has been the federal funds rate. That is the rate banks charge each other for loans. It’s now at a record low near zero.

The rate paid on banks’ excess reserves is 0.25 percent. Boosting that rate would give banks an incentive to keep money parked at the Fed, rather than lend it.

It also would cause the funds rate to rise, economists say. Adjusting the interest paid on banks’ excess reserves helps stabilize the funds rate when the financial system is awash in cash.

Paying interest on the reserves is a relatively new tool for the Fed, having been authorized by a 2008 law. Many foreign central banks rely on it. The Fed started paying interest on the reserves at the height of the financial crisis in October 2008.

Deciding when and how to remove all the stimulus is the biggest challenge for Bernanke in his second term, which started last week. Reeling in the stimulus too soon risks short-circuiting the recovery. That could send unemployment up. But leaving the stimulus measures in place too long could help stir inflation.

Bernanke repeated the Fed’s pledge to hold rates at record lows for an “extended period.’’ Economists think that means for at least six more months. But Bernanke cautioned the Fed eventually will need to raise rates to ease inflationary pressures.