AP

IT HAS been a long time since comments on the economy by an official of America's Federal Reserve comments could be described as cheerful. Yet there was no denying the upbeat tone of Ben Bernanke's testimony to Congress on Tuesday July 21st.

Markets have experienced “notable improvements,” the Fed's chairman told Congress. The fear of investors has “eased somewhat,” and “many markets are functioning more normally.” As for the economy, consumer spending has been stable, the drop in the housing market has moderated and many “of our trading partners are also seeing signs of stabilisation.” His fingers may be crossed but it is clear that Mr Bernanke thinks the recession, if not over now, soon will be.

That is a far cry, though, from seeing a threat from inflation and Mr Bernanke made it clear that the federal funds target rate, now near zero, will remain there for a long time. On Wall Street, most reckon that means until well into 2010 at least.

Yet the Fed is already under pressure to explain how it intends to tighten monetary policy, even by congressmen who usually want nothing of the sort. The source of their angst is the explosion in the size of the Fed's balance sheet. It has financed its emergency loans to the financial system and purchases of long-term government and mortgage-related bonds (the latter designed to push down long-term interest rates) by printing money, or, more technically, creating new reserves for banks. Such reserves now stand at $782 billion compared with a typical level of around $10 billion before the crisis. And people who know nothing else about inflation do understand that it is what you get if you print enough money.

In fact the connection between bank reserves and inflation is rather weak. Inflation is the result of demand exceeding supply. Excess reserves are only a problem if banks turn them into new loans that generate new spending. That's unlikely to happen when the demand for credit is in the ditch and loan losses are crimping banks' capital and lending capacity.

Still, both loan demand and bank capital will be healthy again some day. Whether inflation follows depends on if the Fed raises interest rates in time and thereby curbs the appetite for credit. Mr Bernanke spent much of his testimony explaining how he can do just that. First, the Fed can pay higher interest on those reserves, giving an incentive to banks to leave them at the Fed rather than turn them into loans. It could, if necessary, induce banks to lock up the reserves for long periods by offering them the equivalent of certificates of deposit. It could soak up those reserves by borrowing from financial firms in the form of secured loans called “reverse repos.” And if necessary, it could sell some of its bonds, which would push up long-term interest rates. That, though, is not a preferred option.

Politics could also interfere with the Fed's willingness to tighten monetary policy in time. Congress's nonpartisan investigative arm, the Government Accountability Office, can now audit the Fed with the exception of its monetary policy, lending programmes or relations with foreign central banks. A bill in Congress would lift those prohibitions. Mr Bernanke argued that the threat of such audits would lead investors to question the Fed's willingness to do unpopular things, like tighten monetary policy, unsettling them and driving up long-term interest rates.

This is not idle speculation. Anti-Fed sentiment was also strong in the 1970s, when Congress first sought to have the GAO audit the central bank. Arthur Burns, chairman at the time, fought back, and a compromise was struck to allow audits, but with the current prohibitions. Mr Burns later reflected that the effort of “warding off legislation that could destroy any hope of ending inflation” involved “political judgments” that may have weakened his anti-inflationary resolve.

For all the discussion, any tightening of policy is a long way off. Housing may be stabilising but Mr Bernanke noted that commercial-property borrowers are struggling to refinance; their defaults may pose the next big threat to the banking system.While the threat of deflation disappeared from the Fed's official post-meeting statement last month, it reappeared in the monetary-policy report that accompanied Mr Bernanke's testimony. The focus of monetary policy, it said, is “to prevent a sustained decline in inflation below levels consistent” with the Fed's goals. The report also noted that despite their success in raising new capital, banks' lending contracted by nearly 7% at an annual rate in the first half of the year. That's due both to lower demand and tighter lending standards: unused lines of credit fell by a dramatic 30% in the first quarter.

Indeed, further easing should not be ruled out. But how? Not only is the Fed funds rate in effect at zero, but the Fed's foray into bond buying did not have the intended impact on long-term rates: they have risen, not fallen. That is partly because of lower panicked demand for the shelter of bonds but also fear that such purchases would ultimately lead to inflation. No wonder Mr Bernanke likes to discuss his options for tightening monetary policy; they are better than his options for easing.