Bernanke lays out thinking on Fed policy

WASHINGTON (Reuters) - Following are highlights from the text of U.S. Federal Reserve Chairman Ben Bernanke's speech at the London School of Economics.

ON THE OUTLOOK NEED FOR ACTION

"For almost a year and a half the global financial system has been under extraordinary stress -- stress that has now decisively spilled over to the global economy more broadly ... The damage, in terms of lost output, lost jobs, and lost wealth, is already substantial. The global economy will recover, but the timing and strength of the recovery are highly uncertain. Government policy responses around the world will be critical determinants of the speed and vigour of the recovery."

STABILIZING FINANCIAL SYSTEM

"The Federal Reserve will do its part to promote economic recovery, but other policy measures will be needed as well. The incoming Administration and the Congress are currently discussing a substantial fiscal package that, if enacted, could provide a significant boost to economic activity. In my view, however, fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilise and strengthen the financial system..."

"... with the worsening of the economy's growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions. Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets. A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. Should the Treasury decide to supplement injections of capital by removing troubled assets from institutions' balance sheets, as was initially proposed for the U.S. financial rescue plan, several approaches might be considered. Public purchases of troubled assets are one possibility. Another is to provide asset guarantees, under which the government would agree to absorb, presumably in exchange for warrants or some other form of compensation, part of the prospective losses on specified portfolios of troubled assets held by banks. Yet another approach would be to set up and capitalise so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank."

FED'S POLICY APPROACH VS. QUANTITATIVE EASING

"The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach -- which could be described as "credit easing" -- resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental....

"The stimulative effect of the Federal Reserve's credit easing policies depends sensitively on the particular mix of lending programs and securities purchases that it undertakes. When markets are illiquid and private arbitrage is impaired by balance sheet constraints and other factors, as at present, one dollar of longer-term securities purchases is unlikely to have the same impact on financial markets and the economy as a dollar of lending to banks, which has in turn a different effect than a dollar of lending to support the commercial paper market. Because various types of lending have heterogeneous effects, the stance of Fed policy in the current regime -- in contrast to a QE regime -- is not easily summarized by a single number, such as the quantity of excess reserves or the size of the monetary base. In addition, the usage of Federal Reserve credit is determined in large part by borrower needs and thus will tend to increase when market conditions worsen and decline when market conditions improve. Setting a target for the size of the Federal Reserve's balance sheet, as in a QE regime, could thus have the perverse effect of forcing the Fed to tighten the terms and availability of its lending at times when market conditions were worsening, and vice versa."