WASHINGTON — Federal Reserve Chairman Ben Bernanke on Wednesday outlined the likely path the central bank will take to tighten credit once the economy has recovered enough.
In prepared testimony for the House Financial Services Committee, the Fed chief said the rate paid to banks on excess reserves held at the central bank may for a time replace the Fed funds rate as the main operating target for policy.
As part of the Fed's plans to end its liquidity programs, Bernanke also said the central bank could "before long" increase the spread, or difference, between the discount rate it charges banks for emergency loans and the Fed funds rate.
To combat the worst financial crisis in decades, the Fed slashed short-term rates to near zero in December 2008 and implemented an array of emergency lending and long-term asset purchases programs to keep long-term rates down.
"It is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance," Bernanke said, adding no final decision has yet been made.
The Fed currently pays banks a 0.25% rate for the more than $1.1 trillion they hold at the central bank.
Raising the rate would give banks an incentive to park more funds at the Fed instead of lending it out to companies or households. In this way, the Fed would in the future be able to restrain an economy that is overheating and running the risk of sparking inflation.
Bernanke said the Fed expects such a move to pull up other key short-term rates, including the federal-funds rate at which banks lend to each other overnight--long the Fed's main tool for steering the economy.
While other major central banks, such as the European Central Bank, have been using interest on excess bank reserves for a while, it's a relatively new tool in the U.S.
Congress gave the Fed the authority to use it in October 2008.
Bernanke said the sequencing and tools the Fed will use to tighten policy will depend on how the economic recovery develops.
The Fed chief said the economy still needs highly accommodative policy for now, but the central bank will "at some point" have to increase short-term rates and cut excess bank reserves.