Markets respond positively as Bernanke says US is ready to act

Federal Reserve chairman Ben Bernanke has said the US is ready to act if further monetary policy supportive measures are required to shore up the country's economy.

Bernanke said that "the recent economic weakness may prove more persistent than expected" and if deflationary risks re-emerged, "implying a need for additional policy support… we have a number of ways in which we could act to ease financial conditions further".

The yield on ten-year US treasuries gained 1.89% on Wednesday, trading at 2.94%. US equity markets also reacted positively to the announcement, as the Standard & Poor's 500, a US stock index, gained 1.27% for the day and traded at 1,330.50 at 16:00 UK time.

The chairman said one option for action would be to "provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels", to prevent concern about when policy tightening may occur.

Another step would be to "initiate more securities purchases or to increase the average maturity of our holdings", Bernanke suggested.

The Federal Reserve could also consider reducing the 25-basis point rate of interest it pays to banks on their reserves, "thereby putting downward pressure on short-term rates more generally", said Bernanke.

The chairman was noticeably cautious in proposing these ideas, however, saying that the Fed's "experience with these policies remains relatively limited, and employing them would entail potential risks and costs". However, Bernanke said "prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant."

After offering up the possibilities for action were the economy to dip again, Bernanke moved on to discuss measures open for more positive outcomes.

"The economy could evolve in a way that would warrant a move toward less-accommodative policy," said Bernanke.

The Federal Open Market Committee released the minutes from their June 21–22 meeting on Tuesday, and within them it was revealed that the decision-makers have reached, as Bernanke put it, "a broad consensus about the sequence of steps that it expects to follow when the normalisation of policy becomes appropriate".

This is a positive announcement from the Fed, where disagreement over the US exit strategy has rumbled on.

"When economic conditions warrant, the Committee would begin the normalisation process by ceasing the reinvestment of principal payments on its securities, thereby allowing the Federal Reserve's balance sheet to begin shrinking," said Bernanke. "At the same time or some time thereafter, the Committee would modify the forward guidance in its statement. Subsequent steps would include the initiation of temporary reserve-draining operations and, when conditions warrant, increases in the federal funds rate target."

He said after that time, "changing the level or range of the federal funds rate target would be our primary means of adjusting the stance of monetary policy in response to economic developments."

FOMC minutes

The FOMC minutes still showed some disagreement among the members, however. In discussing the medium-term outlook for monetary policy, some participants "noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory shocks dissipated, it would be appropriate to provide additional monetary policy accommodation".

Other members believed the recent configuration of slower growth and higher inflation could suggest that there might be less slack in labour and product markets than had been thought.

"Several participants observed that the necessity of reallocating labour across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, may have temporarily reduced the economy's level of potential output. In that case, the withdrawal of monetary accommodation may need to begin sooner than currently anticipated in financial markets," said the minutes.

"A few participants expressed uncertainty about the efficacy of monetary policy in current circumstances, but disagreed on the implications for future policy," the notes said.