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Fed Gently Talks Tightening

Fed Chairman Ben Bernanke lays out what steps the central bank could take to exit some of its easy money policies. <I>TheStreet</I> talks to Fed-watchers.
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WASHINGTON (

TheStreet

) -- As

Federal Reserve

Chairman Ben Bernanke on Wednesday detailed the steps the central bank may take to exit some of its easy monetary policies, some Fed watchers noted that he is following the logical path he has laid out in a fragile economy.

Bernanke, in prepared testimony for the House Financial Services Committee, wrote that "the U.S. economy continues to require the support of highly accommodative monetary policies." But he went on to say that "at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding."

Bernanke was supposed to testify in front of the House committee Wednesday, but it was postponed due to inclement weather. The Fed released the prepared testimony in the morning.

With excess reserves splashing about in the banking system, Bernanke highlighted a few measures the Fed may use to drain reserves, including the use of reverse repos, term deposits and the redeeming or selling of securities. Though he refrained from offering hints on timing, he added the order and usage of tools "will depend on economic and financial developments," and went further in offering some clues to chain of events.

"One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation," Bernanke wrote. "As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates."

"The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves. If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate paid on reserves at about the same time it commences significant draining operations."

Brian Bethune, chief U.S. financial economist at Global Insight, said the statement repeated many ideas that had been communicated by the Fed in the past.

"He's stitching together what the Fed has been saying for some period of time," said Bethune. "It's a report that's designed to reassure lawmakers and the markets that they have a strategy, it's pretty well articulated and they are in the process of dotting the "I's" and crossing the "T's," but the broad pieces of it are in place."

Ben Bernanke

But much of the newer discussion centered on the nitty-gritty of specific options and potential rate increases coming at some point.

After reiterating the Fed's typical verbiage that economic conditions warrant low rates for an extended period of time, Bernanke mulled over a hike to the discount rate, saying they may "consider a modest increase" in the spread between discount rate and the federal funds rate "before long." The discount rate, or the rate charged to banks through its discount window, was dropped to 0.5% during the economic downturn.

But Bernanke also warned about reading too much into the potential move.

"These changes, like the closure of a number of lending facilities earlier this month, should be viewed as further normalization of the Federal Reserve's lending facilities, in light of the improving conditions in financial markets," said Bernanke. "They are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about as it was at the time of the January meeting of the FOMC."

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John Canally, chief economist at LPL Financial, thinks the "extended period" language may be dropped after the March meeting of the Federal Open Market Committee. Though the testimony helped explicate certain ideas, he was left unsure when a specific discount rate hike would come, and noted the sheer volume of proposals continues to leave the market uncertain.

"It's not like it's 2004 when the only thing they were working with was raising the fed funds rate," Canally said. "That made the market nervous enough. Now you have interest in excess reserves. There's the discount rate. There's the fed funds rate. There's the balance sheet. There's the liquidity programs. There's all that uncertainty. Eventually the markets will figure out that

the Fed will do a set of things and do so much. I don't think the market knows any of that now, and they least of all know when they're going to start."

"I think by many indications, the financial system is functioning much more smoothly now," Canally added. "And so, I think, this move on the discount rate reflects the fact that financial market conditions have largely returned to normal. That could come at any time, perhaps."

Bernanke also said the fed funds rate may "become a less reliable indicator than usual of conditions in short-term money markets." The fed funds target has been held at near zero, but the federal funds market has "declined considerably." As a result, the Fed may turn to interest rates on reserves for some time as its benchmark to communicate policy, but Bernanke added no decision has been made.

"I think you'll start to see that happening when unemployment starts to really drop," said Doug Roberts, chief investment strategist at ChannelCapitalResearch.com. "Also, it'll probably come when the banking system starts stabilizing. My guess is its going to be much longer than people are anticipating."

Stocks sold off in the immediate aftermath of the release, but later bounced off their lows. The

Dow

finished 20 points lower, or 0.2%, at 10,038.

Bank stocks moved broadly higher, as the KBW Bank Index rose 1%.

JPMorgan Chase

(JPM) - Get Report

and

Bank of America

(BAC) - Get Report

helped the blue-chip average, adding 1.3% and 1.4%, respectively.

-- Written by Sung Moss in New York