One tool Bernanke mentioned in his February testimony to the Congress is relatively new -- the interest it pays banks for any excess reserves they hold at the Federal Reserve. The Fed can raise the interest rate to encourage banks to continue to hold the money idle at the Fed, so cheap loans won't flood the economy.
This rate is currently 0.25 percent and nowhere near enough for banks to hold back loans when they currently net around 3 percent on new mortgage loans, for example. What then is the purpose of paying such low rate, other than lining banks' pockets?
For one, it keeps a floor under the short-term federal funds rate. The other is perhaps simply to cheaply showcase a new inflation management tool that the Fed might want to use if push came to shove. Just how high should this interest rate be so banks would willingly hold their excess reserves and not want to lend?
A good place to start would be to offer a rate that's as good as what banks can net on loans to businesses and households. This tool would work, but banks would have to deny a lot of new loan requests. Whether such a "freeze" on loans is good business policy for banks or will be supported by the politicians and the public is another matter.
Another new tool the Fed has recently put in place is the so-called reverse repurchase agreement -- the Fed borrows money from the banks for short periods just to lock them up so banks can't use them to make loans.
What else could the Fed possibly do to control the flow of cheap credit to keep inflation at bay? Could the Fed possibly require banks to hold a higher percent of customer deposits in their reserve accounts so excess reserves would be soaked up some?
They can, to a limited degree and for a limited time, after which they must seek congressional approval to continue such policy. The downside of this tool is smaller banks with thin excess reserve cushions that may find it very difficult to build their reserve balance. They may scramble to sell assets and recall or deny loans to restock themselves with reserves to satisfy the law. This disruptive but powerful tool can, thereby, depress asset prices and choke off lending activity of smaller banks for quite a while.
The Fed might, however, want to use all three tools in moderation with the last two primarily to lock up money that banks may otherwise loan out.
With the U.S. economy continuing to recover slowly amid the headwinds of the recent payroll tax increase, state and federal government cuts, high gas cost and the ongoing recession in much of Europe, the Fed would monitor the development closely but not likely roll back any time soon. Bernanke is much more likely to use his new crisis management tools if and when necessary than worry about the next asset bubble that might be in the making already.
Islam is an associate professor of economics at West Virginia State University.