Bernanke's Speech

Some takeaways from the Fed Chairman's speech:

1) Tough talk on the need for banks to realize that the easy days are over:

Ultimately, however, market participants themselves must address the fundamental sources of financial strains by raising new capital, restructuring balance sheets, and improving risk management. This process is likely to take some time.

This echoes remarks made by University of Chicago's John Cochrane in a panel discussion a couple of weeks back. Basically, Cochrane believes that the rapid deterioration of the shadow banking system (CDOs, hedge funds, SIVs) means that the big financial institutions will need to live with holding loans they originate (and the risks associated with them) on their balance sheets.

2) The Fed's still worried about inflation, just not right now:

Expanding the provision of liquidity leads also to further expansion of the balance sheet of the Federal Reserve. To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed's balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.

3) And as much discussed here, Bernanke believes the inability of paying interest on excess reserves to put a floor on the effective fed funds rate is due to the fact that some institutions, like GSEs, aren't eligible to earn that interest:

In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target.1 We will continue to explore ways to keep the effective federal funds rate closer to the target.

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