FACTBOX-Bernanke outlines exit strategy in testimony

Feb 10 (Reuters) - U.S. Federal Reserve Chairman Ben
Bernanke on Wednesday outlined the U.S. central bank's strategy
for tightening monetary policy once it is confident in the
strength of the economic recovery.

The Fed chairman said the U.S. central bank would likely
remove excess cash from the financial system before it raises
benchmark short-term interest rates. For more see
[ID:nN10166741].

In his most comprehensive description to date of how the
Fed would wean the economy and markets off its extensive
emergency support, he also said the bank could soon raise the
discount rate it charges banks for emergency loans. But he
stressed that would not be akin to tightening monetary policy.

Bernanke said the outlook for policy remains "about the
same" as it was at the Fed's last policy meeting on Jan. 26-27,
and repeated the bank's pledge to hold rates exceptionally low
for an extended period.

The Fed cut benchmark rates to near zero in December 2008
and further eased financial conditions by putting in place an
array of liquidity and long-term asset purchase programs.

Following are explanations of the tools and the potential
order in which they may be used.

PAYING INTEREST ON EXCESS RESERVES:

The interest rate the Fed pays on excess reserves will be
the one to watch once the Fed begins to tighten policy.
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By raising the rate it pays on bank reserves, the Fed
essentially creates a magnet for banks to keep those reserves
with the Fed rather than lend them out into the financial
system.

"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," Bernanke said in his Feb. 10 testimony.

A number of central banks around the world have effectively
used similar tools.

LARGE-SCALE REVERSE REPURCHASE AGREEMENTS

The Fed could arrange large-scale reverse repurchase
agreements (reverse repos), with financial market participants.
They would temporarily drain reserves from the banking system
and reduce excess liquidity at other institutions.

Reverse repos involve the sale by the Fed of securities
from its portfolio with an agreement to buy them back at a
slightly higher price at a later date.

The New York Fed last year conducted a number of small
tests of tri-party reverse repurchase agreements. In the
tri-party repo market, clearing banks JPMorgan Chase & Co and
Bank of New York Mellon Corp act as intermediaries.

"By developing the capacity to conduct such transactions in
the tri-party repo market, the Federal Reserve has enhanced its
ability to use reverse repos to absorb very large quantities of
reserves," Bernanke said on Feb. 10.

"The capability to carry out these transactions with
primary dealers, using our holdings of Treasury and agency debt
securities, has already been tested and is currently available.
To further increase its capacity to drain reserves through
reverse repos, the Federal Reserve is also in the process of
expanding the set of counterparties with which it can transact
and developing the infrastructure necessary to use its
(mortgage-backed securities) holdings as collateral in these
transactions," he said.

TERM DEPOSIT FACILITY:

The Fed has proposed creating a new "term deposit facility"
for banks, similar to certificates of deposit that banks offer
retail customers. Like the reverse repos, this would reduce the
supply of funds banks have available to lend to each other.

While the Fed already pays interest on reserves held
overnight, a term deposit facility would lock up funds for
longer. In its proposed rulemaking, the Fed said deposits would
not exceed one year and would likely have maturities ranging
between one and six months.

"The Federal Reserve would likely auction large blocks of
such deposits, thus converting a portion of depository
institutions' reserve balances into deposits that could not be
used to meet their very short-term liquidity needs and could
not be counted as reserves," Bernanke said on Feb. 10.

He said the Fed expects to conduct tests on the term
deposit facility in the spring.

"Reverse repos and the deposit facility would together
allow the Federal Reserve to drain hundreds of billions of
dollars of reserves from the banking system quite quickly,
should it choose to do so," Bernanke said.

ASSET SALES:

The Fed could sell a portion of its securities holdings
into the open market.

"A reduction in securities holdings would have the effect
of further reducing the quantity of reserves in the banking
system as well as reducing the overall size of the Federal
Reserve's balance sheet," Bernanke said on Feb. 10.

"I currently do not anticipate that the Federal Reserve
will sell any of its security holdings in the near term, at
least until after policy tightening has gotten under way and
the economy is clearly in a sustainable recovery," he said.

Bernanke added any sales would be at a gradual pace and
would be clearly communicated to market participants.

The Fed is allowing agency debt and mortgage-backed
securities to run off as they mature or are prepaid, Bernanke
said. It is currently rolling over all maturing Treasury
securities, but Bernanke said that in the future it may choose
not to do so in all cases.

SEQUENCE?

From Bernanke testimony, Feb. 10:

"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 said.

"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."