From the beginning I’ve been an open supporter of Bernanke’s decision to pursue quantitative easing as a strategy for promoting short term liquidity and long term growth, because at the time it made plenty of sense. America’s financial institutions squandered their initial recapitalization funds on private jets and executive severance packages with taxpayer dollars against the behest of the FED . QE meant that the Federal Reserve was going to handle the situation personally, taking on fair levels of risk in the hope that with enough cash on hand, banks would start lending and Americans could finally get back to work. Three years and two trillion dollars later, Corporate America sits comfortably atop a Mount Olympus of inelastic demand with bulging balance sheets of billions in low interest cash and millions of unemployed jobseekers. As the FED gears up to push $40 billion or more a month onto the economy I grow more concerned, because giving bankers money without any legal authority to make them use it just isn’t working. So what’s the world’s most powerful banker to do when all his cards are on the table? Simple, he takes them back.
Instead of continuing to put billions in new cash on the market for corporate America to stockpile, Bernanke should give a pop quiz of sorts for the financial system to
- Determine whether or not continued injections of cheap capital are required to provide liquidity for credit markets
- Ascertain the true cash position and capital reserves of systemically relevant financial institutions
- Create conditions that would dminish Wall Street’s confidence in accelerated levels of monetary stimulus.
To conduct such a test, the Federal Reserve should reduce its monthly asset purchases from $40 billion per month, to $15 billion while simultaneously raising the Federal Funds Rate target range from its current 0.00-0.25 percent to 0.75-1.00 percent. This strategy contracts the stream of government capital flowing into the economy while making the borrowing of money from Federal Reserve Banks more expensive. Ideally, the FED would initiate changes at the beginning of Q2-2013 and continue them until the end of Q3.
The overall aim is to force banks into a position where they would need to dig into their capital reserves and add risk to their balance sheets. The test intentionally contracts the markets primary supply of liqudity with a $25 billion reduction in QE spending, meaning that the gap would have to be compensated for by the financial sector. Then the FED sells some its risk back onto the market to raise short term interest rates, which will expose the real strength of the banking sector, as interbank loan interest would increase in relation to Federal Funds. Markets alongside the FED would be able to assess the cash positions and capital reserves of the nation’s banks, as institutions with ample reserves in cash will be able to take on more risk through lending, and also will be able to borrow at lower interest rates. Banks unable or unwilling to cope with higher rates would be discovered and the central bank would have a clearer idea of where to lend, rather than filtering capital through the entire banking system.
Given Bernanke’s committment to accomodative policy until America makes significant headway on unemployment and growth, it’s unlikely the Federal Reserve would pursue this course. However, QE’s power to catalyze growth throughout the broader economy wanes with each use, as firms prefer to simply garrison the cash rather than invest it through job creation and hiring. With Congress embroiled in the debate over tax and entitlement reform, fiscal policy to address this problem isn’t likely to arrive anytime soon. This problem falls to the FED to resolve, and something has to give.