Bernanke has some explaining to do

The head of the central bank heads to Capitol Hill on Wednesday and Thursday for twice-yearly testimony, fulfilling a long-time practice.

Normally, the main topic is the state of the .

This time, Bernanke will also have to answer why he decided to spring a surprise on financial markets last week by raising the interest rate the Fed charges on emergency loans to banks – and whether that signals the days of easy money are over.

Higher borrowing costs would be unwelcome news to Congress, where the majority of lawmakers are up for re-election and want low rates to foster economic growth and keep voters happy.

Bernanke was already under pressure from some lawmakers who thought he failed to see the financial crisis coming and mishandled the fallout. Thirty senators voted against him serving a second term as chairman, the stiffest opposition in the nearly 32 years the Senate has voted on the position.

He can expect to hear more of that criticism this week as lawmakers debate how best to reform financial regulation, and how large a role the Fed ought to play.

When the Fed announced the hike in the so-called discount rate on Thursday, it went out of its way to say this would not raise borrowing costs for households or consumers.

The numbers back that up. The rate hike affects only the Fed's “discount window” for emergency loans, and borrowing there averaged $87.73bn a day in the week ended February 17. Paying an extra 0.25 percent interest on that amount works out to just $219m – a drop in the bucket for multitrillion-dollar global credit markets.

Why now?
That the central bank was to raise the discount rate was well known. Bernanke himself had said on February 10 a move would probably come soon as the Fed tries to encourage banks to resume borrowing from the private sector.

But the timing raised questions. Why did the Fed deem it necessary to raise the rate last week? Couldn't it wait until its next scheduled policy meeting on March 16? And if not, why didn't the Fed make this move at its January 27 meeting?

The result was a new wave of speculation that the Fed was closer to raising its benchmark interest rate, which governs lending between banks, than markets had assumed, said Brian Bethune, an economist with IHS Global Insight in Lexington, Massachusetts.

“Hopefully, Bernanke's testimony to Congress … will shed some important new light on the Fed's policy intentions,” he said.

Jack Ablin, chief investment officer at Harris Private Bank in Chicago, said he expected Bernanke to reassure both lawmakers and investors that borrowing costs are not heading higher any time soon.

In fact, by taking smaller steps such as raising the discount rate and talking about the need to normalise policy, Bernanke can buy himself some more time to keep rates low.

Financial market players tend to react to tightening talk by pushing up the dollar, which eases inflation pressure and gives the Fed some breathing room.

“In his heart, I don't think he has any intention of raising rates this year,” Ablin said. “In order to do that, he has to jawbone. The more they can talk and flap their arms, the less they have to raise rates.”

To make matters even more complicated for Bernanke, his testimony comes in the midst of debate over how to reform financial regulation to ward off the next crisis.

Senator Christopher Dodd, chairman of the Senate Banking Committee where Bernanke will be testifying on Thursday, and Republican Senator Bob Corker are expected to unveil a bipartisan financial reform bill this week.

The Fed's role in that remains to be seen. Bernanke thinks the central bank is best placed to serve as systemic risk regulator, overseeing the largest financial firms to ensure they don't take on too much risk.

Dodd opposes putting the Fed at the centre of systemic risk regulation, and will probably seek to curb its powers.

Between the drama over the discount rate hike and the debate over regulation, Bernanke's view of the economy may be a bit overshadowed. Look for him to give a brighter view of growth prospects, if anyone is still listening.

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