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Bernanke sees higher interest rates ahead

The Federal Reserve's Ben Bernanke outlined the strategy for eventually tightening credit.
The Federal Reserve's Ben Bernanke outlined the strategy for eventually tightening credit.
Alex Brandon, Associated Press

WASHINGTON — Prepare for the end of record-low interest rates, Federal Reserve Chairman Ben Bernanke says. Just not yet.

Higher rates on credit cards, home equity loans and some mortgages will follow the Fed's eventual pullback of the trillions it injected into the economy. Savers will benefit, though. As rates gradually climb, certificates of deposit and savings accounts will finally pay more.

Bernanke indicated Wednesday that the Fed is still months away from raising rates or draining most of the stimulus money it injected to rescue the financial system.

For now, the global recovery remains too fragile to pull back much on government stimulus. Europe is facing a debt crisis. And President Barack Obama is making a push to cut taxes to stimulate job creation.

Bernanke discussed the Fed's plans in prepared remarks to a House committee hearing that was postponed because of the East Coast snowstorm. Bernanke chose to release the testimony because of interest from investors and others.

His testimony outlined the Fed's strategy for reeling in stimulus money once the economic recovery is more firmly rooted.

To fight the financial crises, the Fed pumped so much money into the economy for lending programs that its balance sheet swelled to $2.2 trillion — more than double the pre-crisis level.

Bernanke said the central bank will likely start to tighten credit by boosting the rate it pays banks on money they leave at the central bank. Doing so would raise rates tied to commercial banks' prime rate and affect many consumer loans.

Bernanke sought to bolster confidence on Wall Street and in Congress that once the economy is strong enough, the Fed has the tools and the will to raise rates and withdraw stimulus aid — without causing another recession. The goal would be to prevent another speculative asset bubble from forming, such as in stocks or commodities, and ward off inflation.

The stock market initially sank, then steadied itself after hearing Bernanke's plans. Investors seemed relieved that the plans didn't mark a shift in policy, and that they set a path for a more normal financial system. The Dow Jones industrial average closed with a modest loss of 20 points.

Using the rate it pays on banks' excess reserves to tighten credit would be a new strategy for the Fed. Since the 1980s, its main lever to adjust credit has been the federal funds rate. That's the rate banks charge each other for loans. It's now at a record low near zero.

The rate paid on banks' excess reserves is 0.25 percent. Boosting that rate would give banks an incentive to keep money parked at the Fed, rather than lend it.

Steering interest rates through the excess reserves rate gives the Fed more control over money floating around the financial system. The Fed sets that rate directly, while its federal funds rate is just a target.

For consumers and businesses, the shift in which tool the Fed uses to tighten credit would make little practical difference, economists say. A bump-up in either the rate on excess reserves or the federal funds rate would have an identical result: It would boost the prime lending rate, now at 3.25 percent, by the same amount.

The prime rate is used to peg rates on home equity loans, certain credit cards and other loans to consumers and small businesses.

Rates on fixed 15- and 30-year mortgages are influenced mainly by rates on 10-year Treasury securities and wouldn't be directly affected by a Fed tightening. But a bump-up in the Fed's rate on excess reserves would raise short-term Treasury rates and the adjustable home mortgages they're often linked to.

A higher rate on banks' excess reserves would make it harder to borrow. Banks will be tempted to keep more money at the central bank, rather than lend it to individuals and businesses.

"It's a warning shot for borrowers," said Greg McBride, senior financial analyst at "Banks are not going to lend to XYZ Corp. or John Homeowner and bear the risk of default if they can instead earn a risk-free return by keeping that money with the Federal Reserve."

How high rates would go on credit card and home equity loans would depend on the speed with which the economy and loan demand recovers. But because rates are sure to head up, "now is the time to lock in low fixed rates and pay down higher-rate variable debt, especially credit cards," McBride added.

What's bad for borrowers will be good for savers, who have been hurt by record-low interest rates. As rates climb, people with interest-bearing investments like CDs will earn more, McBride said.

In his remarks, Bernanke laid out his most extensive details to date on the Fed's exit strategy from record-low rates and economic stimulus.

Deciding when and how to remove all the stimulus is the biggest challenge for Bernanke in his second term, which started last week. Reeling in the stimulus too soon risks short-circuiting the recovery. That could send unemployment up.

If the Fed keeps its stimulus measures in place for too long, they could help unleash inflation.

Bernanke repeated the Fed's pledge to hold rates at record lows for an "extended period." Economists think that means for at least six more months.

"The Fed is trying to show Wall Street and Congress 'We've done our homework, and we have a strategy for getting back to normal,'" said Brian Bethune, economist at IHS Global Insight. "This is all designed to build confidence in the Fed's exit strategy."

Even before the Fed raises the rate paid on banks' excess reserves, it could raise the rate it charges banks for emergency loans, Bernanke said. That rate, called the discount rate, is 0.50 percent. An increase in the discount rate wouldn't affect interest rates charged to consumers and businesses.

The Fed is fine-tuning one tool to withdraw money: By selling securities from its portfolio with an agreement to buy them back later. Those operations are called reverse repurchase agreements.

And the Fed is moving ahead on a proposal to let banks to set up the equivalent of certificates of deposit at the central bank. This, too, would help the Fed mop up money pumped into the economy and prevent inflation from flaring later.

Bernanke said he doesn't expect the Fed to sell any of its securities any time soon.

Bernanke said another economic support program aimed at driving down mortgage rates and bolstering the housing market is on track to end in March.

Ending this program would likely send mortgage rates higher. But the Fed hasn't ruled out continuing to buy mortgage securities after March to support the economy.