By Steven K. Beckner

WASHINGTON (MNI) - Federal Reserve Chairman Ben Bernanke not only signaled Wednesday that short-term interest rates would be kept near zero "for an extended period," he said the Fed will "evaluate" whether additional monetary stimulus of some sort is needed.

Unemployment, not inflation, is "the biggest problem we have," he said.

In testimony prepared for the House Financial Services Committee, Bernanke left the door open to further purchases of mortgage backed securities and agency debt beyond March, and in response to questions from committee members, he said the Fed would also be evaluating whether it should extend its financing of new commercial mortgage backed securities past June.

Bernanke, presenting his semi-annual Monetary Policy Report to Congress on behalf of the Federal Open Market Committee, called the Fed's current monetary policy, which includes a 0-0.25% federal funds rate target and $1.1 trillion in bank reserves, "highly accommodative" and "very stimulative."

But when asked whether yet more monetary stimulus is needed to increase economic growth and spur job creation, Bernanke replied, "The FOMC is going to have to continue to evaluate whether additional stimulus would be necessary depending how the economy evolves, so we'll continue to look at that."

He did not elaborate on what form such "additional stimulus" might take. The Fed has no room to lower interest rates further, but it could do more quantitative easing through purchases of Treasury, agency and agency-backed MBS.

That is not the present intention. The Fed ended Treasury purchases last fall and has scheduled the end of agency and agency-backed MBS for the end of March. And Bernanke again described tools the Fed has developed for shrinking or at least absorbing the reserves created through past purchases.

But in his prepared testimony, Bernanke said, "The FOMC will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets."

Later, he said the Fed is "interested to see what the effect will be" of ceasing to buy MBS. "So far it looks like it will be modest."

TALF financing of "legacy" or older CMBS is due to expire on March 31. TALF loans backed by newly issued CMBS is set to expire on June 30. But in response to a question, Bernanke said the Fed will also "evaluate" whether the TALF should expire as scheduled.

He said the TALF has been "successful" in reducing spreads in the CMBS market, but he said the commercial real estate market is still fraught with problems that have broader implications for credit availability.

Commercial real estate (CRE) loans are "the biggest credit issue that we still have." He traced the increase in the number of problem banks to CRE exposure. "There are a lot of troubled commercial real estate properties and they are causing a lot of problems for banks, particularly small- to medium-sized banks and we're watching them very carefully," he said.

To the extent that small and medium-sized regional banks are hurt by CRE-related losses, he said the supply of credit could be further restricted.

Bernanke spoke in his prepared testimony about the Fed's ability to sell securities at some point to shrink its balance sheet and the supply of reserves, but he gave no indication he is eager to do that in response to questions.

On the contrary, Bernanke said the Fed will continue to hold the MBS it has bought and said this will "continue to hold down mortgage rates."

"It is true that we will stop buying new mortgage backed securities at the end of this quarter, but we continue to hold one and a quarter trillion dollars of agency mortgage backed securities, and taking that off the market in itself will keep mortgage rates below what they otherwise would be," he said. "So we believe that there will be stimulus coming from our holdings of those securities as well as our low interest rates."

"So we believe the economy as apposed to the money markets for example still requires support for recovery," he added.

Bernanke reinforced his easy money message by stressing the nation's unemployment problems and downplaying inflation risks.

In the prepared testimony, he said labor markets remain "quite weak" and said inflation "likely will be subdued for some time." In response to questions, he asserted, "unemployment is the biggest problem we have."

In fact, Bernanke did not rule out the possibility that deflation risks could revive. "Right now, we don't see deflation as an imminent risk," he said, adding that "inflation expectations are around 2% or higher." But he added, "there are scenarios in which it (deflation) could become more of a concern."

In addition to its traditional and unconventional monetary easing procedures, Bernanke made clear that the Fed is also using its supervisory powers to "get credit flowing again." He strongly suggested that the Fed is leaning on banks to make more loans.

In its examinations, he said the Fed has been asking banks questions to make sure that "creditworthy borrowers," especially small businesses, are not being denied credit.

Bernanke said the Fed is "working very hard" to make sure small business has adequate credit availability. He said the Fed has "incensed information gathering" to find out "how many loans have been turned down."

"There are some cases where tighter (lending) standards are justified," he said, but he added that the Fed "want(s) to make sure creditworthy (borrowers) are not being turned down ... . We don't want banks to made bad loans ... but where a borrower is creditworthy we want banks to make loans ... . We're working very hard to make sure that is not the case."

As he did in prepared testimony, Bernanke stressed again that the Fed's 25 basis point increase in the discount rate last week does not constitute monetary tightening, nor does it signal it.

"The reason we took action was to reduce the subsidy" to banks borrowing from the discount window, he said, adding, "I do not expect any effect whatsoever" of the discount rate hike on money market rates.

In his prepared testimony, Bernanke said that "by increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates."

In response to questions, he suggested that raising the rate of interest on excess reserves will suffice to put a floor under the federal funds rate. "We think that the interest rate we pay on reserves will bring along with it the federal funds rate within tens of basis points, not a tremendous difference," he said.

His comment would seem to suggest that the Fed will not necessarily abandon the federal funds rate as its main monetary policy instrument or target and replace it with the IOER.

Without the additional tools the Fed has developed -- interest on reserves, large reverse repurchase agreements, a proposed term deposit facility -- Bernanke said that "with so many reserves in the system, we wouldn't be able to raise the federal funds rate.

But with those tools, he said the Fed should be able "to raise interest rates notwithstanding the fact that we have a large balance sheet."

Bernanke said "none of them (the tools) has been completely tested," but he said the Fed has a "belt-and-suspenders" capability. He said "interest on reserves itself could be used to tighten policy" but said the Fed could supplement that tool if necessary by using other tools to drain reserves.

Bernanke acknowledged that raising the interest paid on reserves (now 25 basis points) "would reduce our profitablility a little bit." But he said "since we're making 4% plus on MBS we would still have quite a bit of margin there." The Fed paid the Treasury a record $46.1 billion in 2009 out of net earnings on its operations.

Regarding the possibility of the Fed issuing its own debt -- so-called "Fed bills" -- Bernanke said the Fed is "not proposing that now." He said the Fed does plan to auction term deposits but only to financial institutions that hold reserves at the Fed.

As he has before, Bernanke warned about the long-term unsustainability of federal budget deficits. As currently projected, he said deficits will range between 4% and 7% of GDP even after the economy has recovered. He said it is "very important that we look at the trajectory" of deficits and reduce them as a percent of GDP.

Bernanke said deficits affect market interest rates not just in the future but "today." He warned that if bond markets lose confidence in U.S. fiscal policy long-term rates could rise in a counterproductive way. So he said "it would be helpful if there were a credible plan for fiscal exit."

A loss of confidence in longer term fiscal policy would push up long rates and be "a drag on the economy, he warned.

What's more, if confidence is lost, "the dollar could decline, which would have potential inflationary impact," he added.

** Market News International Washington Bureau: 202-371-2121 **