U.S. Federal Reserve Board chairman Ben Bernanke Wednesday outlined some of the technical steps the Fed might take in reducing the extraordinary level of support still being provided to financial markets and the economy, but that isn’t likely to occur anytime soon.

In testimony to the U.S. House Committee on Financial Servicees, Bernanke described some of the measures the Fed might take to tighten monetary policy and drain liquidity from the U.S. financial system, including possibly temporarily replacing the fed funds rate as the key target rate.

TD Economics notes that Bernanke reiterated that the new interest on reserve policy tool (granted by the Congress in 2008) will be the central tool for draining excess liquidity from the system. The Fed could also use a combination of targets for interest paid on reserves and reserve quantities targets as “a guide for its policy stance”, TD says, meaning these targets would temporarily replace the fed funds rate as the key policy target for the Fed.

“The reason for shifting to the alternate target(s) (at least temporarily) is quite simple, as the Fed’s ability to directly influence the fed funds rate could be compromised by the massive amount of excessive liquidity held in the system,” TD says.

Bernanke also indicated that the Fed’s balance sheet will eventually shrink back to “historically normal”, but that this process will be gradual and based on economic conditions, “and he made clear that this will not take place until after monetary tightening has gotten underway,” TD adds.

“Bernanke reiterated that the FOMC anticipates that economic conditions will warrant exceptionally low levels of the fed funds rate for a extended period, he expects the Fed to begin tightening monetary conditions as the economic expansion matures,” it says.

“Overall, there was no indication by Chairman Bernanke of a near-term shift in the Fed’s monetary policy stance, with the Fed’s policy rate and the size of its balance sheet likely to remain unchanged for the time being. However, there is likely to be fundamental changes to the modus operandi for monetary policy going forward as the Fed shifts its policy stance from monetary accommodation to policy tightening and liquidity draining,” TD concludes.

IE