Bernanke on a Bailout of the Treasury

by: Gary North

On February 10, Ben Bernanke testified to the House Financial Services Committee. The topic: “Federal Reserve’s exit strategy.” His printed testimony contained the familiar promises. The Federal Reserve System will unwind when the economy recovers. Speaking of the TAF and TALF programs, he said:

The exit from these programs is substantially complete: Total credit outstanding under all programs, including the regular discount window, has fallen sharply from a peak of $1-1/2 trillion around year-end 2008 to about $110 billion last week.

This sounded good, but as the charts of the FED’s balance sheet indicate, there has been no reduction of the monetary base.

Bernanke mentioned one tool by which the FED can force up the Federal Funds rate, the rate at which banks lend to each other overnight.

By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.

Why should long rates not decline under such a scenario? If the FED starts hiking the rate paid on reserves, the effect will be to raise short-term rates, no question about that. Banks will lend to the FED and pocket no-risk money. The effect of this will be to end the economic recovery. Why? Because banks will lend to the FED, not to the commercial loan markets.

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