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Recovery Sign: Fed Concerned With Inflation

WASHINGTON (CN) - Tackling fears of inflation, Federal Reserve Chair Ben Bernanke on Wednesday laid out his most specific plans to date on how the Fed would soak up the cash it unleashed on the financial market in responding to the recession, by paying greater interest to large depositors at the Fed and by selling shares from the Fed's portfolio.

But he would not be specific on when the anti-inflationary measures migh be deployed.

He said vaguely that the the measures would not be put in place for an "extended period."

Bernanke also defended the bailout of AIG, saying the entire $116 billion paid out as a result of the AIG debacle would be repaid to taxpayers.

"The board continues to anticipate that the Federal Reseve will ultimately incur no loss on these loans," said Benanke in a prepared statement.

The defense of the bailout and the anti-inflation strategy is taken from Bernanke's 10-page prepared statement before the House Financial Services Committee, originally scheduled for Wednesday. The hearing was delayed as a result of a violent blizzard besieging the capital.

Bernanke, who started his second term last week, released the statement regardless.

"Although 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 wrote.

The Fed more than doubled its balance sheet to $2.2 trillion through drastic measures it took to tackle the financial meltdown: buying up mortgage-backed securities and other bad assets, increasing lending, and lowering short-term bank lending rates to nearly zero to promote borrowing.

If the vast sums of money are left in the market for too long, inflation could result. On the other hand, reigning in the funds too quickly could undermine the recovery and destabilize the market.

Bernanke said the Fed would likely raise the interest it pays to banks on money they leave with the central bank - currently at 0.25 percent - to encourage banks to keep their money with the Fed instead of lending it. Americans and businesses would then have to pay more to borrow in order to compete with the higher Fed rates.

Such a scheme is new for the Fed, which only started paying interest on the reserves at the height of the financial crisis in 2008. It traditionally influenced credit by controlling the federal funds rate, which is placed on short-term loans that banks make to other banks. That rate is currently set at a record low of near zero percent.

The Fed is still tinkering with the order of the steps to take.

The Fed could first collect on its loans, and later boost the rates it pays to soak up the cash in the financial system. If inflation becomes too much of a threat though, the Fed could do both at once to more quickly absorb the money.

The Fed is also considering selling shares from its portfolio with a promise to buy them back later, similar to treasury bonds. Selling shares would be another way of quickly inducing investors to put money into the Fed.

The CD-like deposit account and the treasury bond-like purchases "would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so," Bernanke said.

Bernanke was vague in saying when the strategy to drain the financial system of money would be put in action, but remarked that the recovery will continue to need the support of near-zero interest rates for an "extended period." He said the Fed would be ready "at the appropriate time."

Bernanke also defended the controversial bailouts of American International Group and Bear Stearns, saying he thought taxpayers would be fully repaid, and that the $116 billion issued only represented about 5 percent of the $2.2 trillion on the Fed's balance sheet.

By releasing his statement on a snow-bound day when the capital is shut down, Bernanke whether intentionally or not avoided critical commentary from lawmakers concerning his anti-inflationary strategy. At the same time, the statement is likely to make news because the government is otherwise stalled by weather.

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