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Fed's Credit-Tightening Strategy Comes into Focus

5925790The Federal Reserve is beginning to map out how it plans to gradually tighten credit after the economy has sufficiently recovered from the drastic recession.

The Fed slashed short-term interest rates to zero and pumped trillions of dollars into the market to keep credit flowing through the financial crisis. But now the central bank is strategizing how best to counteract those moves, lest inflation start to creep up.

According to a Wall Street Journal report ($), one of those measures will be to raise the "interest on excess reserves" – a rate the Fed pays banks on money they leave on reserve in the central bank. The rate – which Congress authorized in 2008 – is currently at 0.25 percent.

If the Fed hikes the interest paid on excess reserves, banks will have greater incentive to leave more money there. That means there will be less money available for banks to lend to consumers and other banks, driving the price of borrowing up.

Timing will be key: If the Fed waits too long, it risks inflation; Not long enough and it could undercut the economic recovery.

Federal Reserve Chairman Ben Bernanke will begin outlining the central bank's proposed measures this week. He testifies Wednesday before the House Financial Services Committee.

According to the report, the Fed has to use the interest paid on excess reserves as an alternative to controlling short-term interest rates because it has pumped so much money into the banking system that usual methods may not work.

The report also notes other elements to the Fed's credit-tightening plan. The central bank is on pace to buy up to $1.25 trillion of mortgage-backed securities to keep mortgage rates down and prop up the housing market. But the Fed will likely look to gradually sell off those holdings.

The Fed will also change its pattern for hiking interest rates, injecting more unpredictability into the equation, according to the report. Between 2004 and 2006, the Fed raised rates by quarter-point 17 straight times. The consistency of their message and actions actually helped create the conditions for the financial crisis by making the economic forecast appear more stable than it was.