JACKSON HOLE, Wyo. (MNI) – The following is the third section of
the text of the remarks of Federal Reserve Chairman Ben Bernanke
prepared for his Jackson Hole address Friday morning:

In the remainder of my remarks I will discuss the policies the
Federal Reserve is currently using to support economic recovery and
price stability. I will also discuss some additional policy options that
we could consider, especially if the economic outlook were to
deteriorate further. Federal Reserve Policy

In 2008 and 2009, the Federal Reserve, along with policymakers
around the world, took extraordinary actions to arrest the financial
crisis and help restore normal functioning in key financial markets, a
precondition for economic stabilization. To provide further support for
the economic recovery while maintaining price stability, the Fed has
also taken extraordinary measures to ease monetary and financial
conditions.

Notably, since December 2008, the FOMC has held its target for the
federal funds rate in a range of 0 to 25 basis points. Moreover, since
March 2009, the Committee has consistently stated its expectation that
economic conditions are likely to warrant exceptionally low policy rates
for an extended period. Partially in response to FOMC communications,
futures markets quotes suggest that investors are not anticipating
significant policy tightening by the Federal Reserve for quite some
time. Market expectations for continued accommodative policy have in
turn helped reduce interest rates on a range of short- and medium-term
financial instruments to quite low levels, indeed not far above the zero
lower bound on nominal interest rates in many cases.

The FOMC has also acted to improve market functioning and to push
longer-term interest rates lower through its large-scale purchases of
agency debt, agency mortgage-backed securities (MBS), and longer-term
Treasury securities, of which the Federal Reserve currently holds more
than $2 trillion. The channels through which the Feds purchases affect
longer-term interest rates and financial conditions more generally have
been subject to debate. I see the evidence as most favorable to the view
that such purchases work primarily through the so-called portfolio
balance channel, which holds that once short-term interest rates have
reached zero, the Federal Reserves purchases of longer-term securities
affect financial conditions by changing the quantity and mix of
financial assets held by the public. Specifically, the Feds strategy
relies on the presumption that different financial assets are not
perfect substitutes in investors portfolios, so that changes in the net
supply of an asset available to investors affect its yield and those of
broadly similar assets. Thus, our purchases of Treasury, agency debt,
and agency MBS likely both reduced the yields on those securities and
also pushed investors into holding other assets with similar
characteristics, such as credit risk and duration. For example, some
investors who sold MBS to the Fed may have replaced them in their
portfolios with longer-term, high-quality corporate bonds, depressing
the yields on those assets as well.

The logic of the portfolio balance channel implies that the degree
of accommodation delivered by the Federal Reserves securities purchase
program is determined primarily by the quantity and mix of securities
the central bank holds or is anticipated to hold at a point in time (the
“stock view”), rather than by the current pace of new purchases (the
“flow view”). In support of the stock view, the cessation of the

Federal Reserve’s purchases of agency securities at the end of the
first quarter of this year seems to have had only negligible effects on
longer-term rates and spreads.

The Federal Reserve did not hold the size of its securities
portfolio precisely constant after it ended its agency purchase program
earlier this year. Instead, consistent with the Committee’s goal of
ultimately returning the portfolio to one consisting primarily of
Treasury securities, we adopted a policy of re-investing maturing
Treasuries in similar securities while allowing agency securities to run
off as payments of principal were received. To date, we have realized
about $140 billion of repayments of principal on our holdings of agency
debt and MBS, most of it prior to the end of the purchase program.
Continued repayments at this pace, together with the policy of not
re-investing the proceeds, were expected to lead to a slight reduction
in policy accommodation over time.

However, more recently, as the pace of economic growth has slowed
somewhat, longer-term interest rates have fallen and mortgage
refinancing activity has picked up. Increased refinancing has in turn
led the Feds holding of agency MBS to run off more quickly than
previously anticipated. Although mortgage prepayment rates are difficult
to predict, under the assumption that mortgage rates remain near current
levels, we estimated that an additional $400 billion or so of MBS and
agency debt currently in the Feds portfolio could be repaid by the end
of 2011.

At their most recent meeting, FOMC participants observed that
allowing the Federal Reserves balance sheet to shrink in this way at a
time when the outlook had weakened somewhat was inconsistent with the
Committees intention to provide the monetary accommodation necessary to
support the recovery. Moreover, a bad dynamic could come into at play:
Any further weakening of the economy that resulted in lower longer-term
interest rates and a still-faster pace of mortgage refinancing would
likely lead in turn to an even more-rapid runoff of MBS from the Feds
balance sheet. Thus, a weakening of the economy might act indirectly to
increase the pace of passive policy tightening–a perverse outcome. In
response to these concerns, the FOMC agreed to stabilize the quantity of
securities held by the Federal Reserve by re-investing payments of
principal on agency securities into longer-term Treasury securities. We
decided to reinvest in Treasury securities rather than agency securities
because the Federal Reserve already owns a very large share of available
agency securities, suggesting that reinvestment in Treasury securities
might be more effective in reducing longer-term interest rates and
improving financial conditions with less chance of adverse effects on
market functioning. Also, as I already noted, reinvestment in Treasury
securities is more consistent with the Committees longer-term objective
of a portfolio made up principally of Treasury securities. We do not
rule out changing the reinvestment strategy if circumstances warrant,
however.

By agreeing to keep constant the size of the Federal Reserves
securities portfolio, the Committee avoided an undesirable passive
tightening of policy that might otherwise have occurred. The decision
also underscored the Committees intent to maintain accommodative
financial conditions as needed to support the recovery. We will continue
to monitor economic developments closely and to evaluate whether
additional monetary easing would be beneficial. In particular, the
Committee is prepared to provide additional monetary accommodation
through unconventional measures if it proves necessary, especially if
the outlook were to deteriorate significantly. The issue at this stage
is not whether we have the tools to help support economic activity and
guard against disinflation. We do. As I will discuss next, the issue is
instead whether, at any given juncture, the benefits of each tool, in
terms of additional stimulus, outweigh the associated costs or risks of
using the tool.

Policy Options for Further Easing

Notwithstanding the fact that the policy rate is near its zero
lower bound, the Federal Reserve retains a number of tools and
strategies for providing additional stimulus. I will focus here on three
that have been part of recent staff analyses and discussion at FOMC
meetings: (1) conducting additional purchases of longer-term securities,
(2) modifying the Committees communication, and (3) reducing the
interest paid on excess reserves. I will also comment on a fourth
strategy, proposed by several economists — namely, that the FOMC
increase its inflation goals.

A first option for providing additional monetary accommodation, if
necessary, is to expand the Federal Reserves holdings of longer-term
securities. As I noted earlier, the evidence suggests that the Feds
earlier program of purchases was effective in bringing down term
premiums and lowering the costs of borrowing in a number of private
credit markets. I regard the program (which was significantly expanded
in March 2009) as having made an important contribution to the economic
stabilization and recovery that began in the spring of 2009. Likewise,
the FOMCs recent decision to stabilize the Federal Reserves securities
holdings should promote financial conditions supportive of recovery.

I believe that additional purchases of longer-term securities,
should the FOMC choose to undertake them, would be effective in further
easing financial conditions.

-more-

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