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Feb. 10 (Bloomberg) -- The Federal Reserve may raise the discount rate “before long” as part of the “normalization” of Fed lending, a move that won’t signal any change in the
outlook for monetary policy, Chairman Ben S. Bernanke said.

Bernanke repeated the Federal Open Market Committee statement that low rates are warranted “for an extended period” in testimony prepared for the House Financial Services
Committee. The Fed may also temporarily replace the federal
funds rate as a policy guide with interest it pays on banks’
deposits should fed funds become a “less reliable indicator
than usual,” Bernanke said.

The dollar gained and Treasuries fell as Bernanke previewed what would be the first interest-rate move in more than a year while giving more details on tools that may be used to tighten
credit “at some point.” Bernanke, 56, and his fellow policy
makers are preparing to remove unprecedented monetary stimulus
as the world’s largest economy is forecast to grow at the
fastest pace since 2006.

“Before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate,” Bernanke said. The change is “not expected to
lead to tighter financial conditions for households and
businesses and should not be interpreted as signaling any change
in the outlook for monetary policy, which remains about as it
was at the time of the January meeting of the FOMC.”

Stocks, Dollar

Treasuries fell, pushing the yield on two-year securities up to 0.88 percent from 0.83 percent yesterday. The Standard & Poor’s 500 Index fell 0.2 percent to 1,068.13 at 4:59 p.m. in
New York. The dollar climbed 0.4 percent to $1.3737 per euro
from $1.3797 late yesterday.

“He’s trying to tell people that while the Fed is not contemplating any tightening of monetary policy at the moment, they’re fully prepared to do what’s necessary to ensure that
their commitment to price stability is made effective,” said
former Fed Governor Lyle Gramley, senior economic adviser at
Potomac Research Group in Washington.

In December 2008, the Fed cut the discount rate, charged on direct loans to commercial banks, to 0.5 percent as it lowered the benchmark federal funds rate, which banks use for overnight
loans to each other, to a range of zero to 0.25 percent. Both
rates have been unchanged since then.

‘Highly Accommodative’

“Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial
conditions by raising short-term interest rates and reducing the
quantity of bank reserves outstanding,” Bernanke, who this
month started his second four-year term as Fed chief, said in
the testimony for a hearing originally scheduled for today and
postponed because of a snowstorm. A new date hasn’t been
announced.

Borrowing through the discount window totaled $14.7 billion as of Feb. 3, down from a record $110.7 billion in October 2008, after the collapse of Lehman Brothers Holdings Inc. Loans
averaged about $197 million a week in the 12 months through July
2007.

A discount-rate change would bring Bernanke back to the first instrument he used when he attacked the financial crisis: lowering the cost of bank liquidity.

Before August 2007, the discount rate was set at one percentage point above the federal funds rate. As bank lending began to freeze that month, the Fed reduced the difference to a
half-point and narrowed it again, to a quarter-point, in March
2008 in conjunction with its rescue of Bear Stearns Cos.

Maximum Loan Term

The central bank has already reduced the maximum term of discount-window loans to 28 days from 90 days, “and we will consider whether further reductions in the maximum loan maturity
are warranted,” Bernanke said.

Once a key barometer of Fed policy, the discount rate has faded in relevance since 1994, when the Federal Open Market Committee began discussing its federal funds rate stance. In
2003, the Fed altered the structure so that the discount rate
was above, rather than below, the benchmark rate.

The Fed incurred no losses on its $1.5 trillion of emergency lending programs, and the Board of Governors “continues to anticipate” it will not lose money on the
bailouts of Bear Stearns and New-York based insurer American
International Group Inc. The Fed’s portion of those rescues
totals about $116 billion, Bernanke said.

Markets Thaw

The Fed’s unprecedented actions under Bernanke have helped thaw credit markets.

The Libor-OIS spread, a gauge of banks’ willingness to lend, has narrowed to 0.10 percentage point from a record 3.64 points in October 2008. The TED spread, the difference between
what the Treasury and banks pay to borrow dollars for three
months, has narrowed to 0.15 percentage point from as high as
4.64 percentage points in October 2008.

Separately, Bernanke said raising the interest rate paid on funds deposited by banks at the Fed, as well as so-called reverse repurchase agreements that temporarily drain cash from
the banking system, will probably be the first tools for
tightening credit.

Bernanke said he doesn’t expect the Fed “in the near term” to sell the $1.43 trillion of housing debt being purchased through next month, “at least until after policy
tightening has gotten under way and the economy is clearly in a
sustainable recovery.” Fed officials may decide “in the
future” to sell securities, he said.

‘Gradual Pace’

“Any such sales would be at a gradual pace, would be clearly communicated to market participants and would entail appropriate consideration of economic conditions,” Bernanke
said.

The purchases have helped push total assets on the Fed’s balance sheet to $2.25 trillion from $925 billion at the start of 2008. Excess reserves in the banking system total more than
$1 trillion.

The central bank can use several tools to temporarily remove those reserves from the financial system and thereby raise the federal funds rate. Bernanke said the Fed is expanding
the set of counterparties for reverse repurchase agreements,
under which it provides securities as collateral in exchange for
a short-term cash loan.

Bernanke’s message is that “people don’t have to look at this large bloated balance sheet and the huge volume of excess reserves and worry that inflation is going to break out all over
the place,” Gramley said.

Exit Sequence

Bernanke said “one possible sequence” of the exit strategy involves first testing tools for draining reserves “on a limited basis.” Then, “as the time for the removal of policy
accommodation draws near, those operations could be scaled up to
drain more significant volumes of reserve balances to provide
tighter control over short-term interest rates,” he said.

The Fed would then execute the “actual firming of policy” by raising the interest rate on bank reserves, Bernanke said. Congress granted the Fed the power in October 2008 as part of
the law creating the $700 billion Troubled Asset Relief Program.

While Fed officials have previously said the deposit rate will play a major role in the exit strategy, Bernanke said the rate may replace the federal funds rate, the policy benchmark
for the past two decades, until reserves are “much lower.”

“It is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance,
while simultaneously monitoring a range of market rates,”
Bernanke said.

Months Away

The Fed may be months away from tightening credit. U.S. central bankers will begin raising rates in November and increase the benchmark lending rate to 0.75 percent by the end
of the year, according to the median estimate of economists
surveyed by Bloomberg News in January.

The U.S. economy will expand 2.7 percent this year, according to the median estimate. The timing and speed of rate increases may also depend on how quickly the economy can begin
to generate job growth.

Some economists said Bernanke left out what investors are really watching for: when the Fed will move to tighten credit.

“I don’t really see a whole lot of clarity of the timing of actions,” said Conrad DeQuadros, senior economist and partner at RDQ Economics LLC, a New York research firm he
founded with John Ryding, a fellow former Bear Stearns Cos.
economist.