Financial System Liquidity & Policy Risk

Liquidity
System liquidity improved in October on both fronts -- money
& credit. The narrow base of money liquidity (cash & checking)
has been growing strongly since mid-2008 and no doubt helped
to arrest the economic free fall. But, by my analysis, the US
economy is still running a cash shortage of nearly $100 bil. This
is a big improvement over the nearly catastrophic $300 bil.
shortfall that was evident in mid-2008, but I think the Fed
would be wise to allow significantly more cash to flow into the
system through 2010.

The much broader measure of credit-driven liquidity did show
some improvement over the past 2 months, as financial firms
now seem to have better access to the commercial paper mkt.

Banking system liquidity has improved from negative to
adequate, as Treasury holdings have increased and commercial
loans have run-off. The boost to balance sheet liquidity is a
necessary building block to sustain economic recovery down the
road.

Banking system capital remains constrained, but it is starting to
look like the worst of the loan loss reserving is past (Reserves
now total about 16% of capital).

Policy Risk
When the Fed loosened reserve requirements in 1992 to make
it easier for commercial banks to absorb a bevy of troubled
S&Ls, Greenspan failed to re-impose the standards after the
transition was completed. This left the banks with an array of
no and low reserve requirement deposits to fund operations and
reduced Fed control over the banking system. Bernanke also
passed on taking up this challenge.

Monetary policy has thus become grotesque -- drain cash in
a voluminous manner when credit surges, and then belatedly
rush to add cash to the system when credit stalls and falls. The
policy of raising or lowering rates in small increments has only
made the process worse. What the Fed must do going forward
is maintain a much better balance between cash and credit in
the system. The obvious choices are to broaden reserve
requirements and to move more dramatically in changing the
Fed Funds rate.

I have discussed this issue in detail several times since I began
this blog in 2005. Now, the Fed faces one of its largest
challenges ever -- managing a bloated balance sheet down as
the economy recovers. There is a large non-borrowed reserve
position in the system, so maybe the Fed can use deposit rates
to manage this position down in lieu of new, tighter reserve
system rules. We'll see.

The challenge has not been tried before, so elevated risk is
involved. The best outcome for the Fed would be to be more
decisive in raising rates and to maintain a better balance
between cash and credit in the system as the economy
recovers. Given the 2 credit tightening debacles we have
seen over the past 10 years, I would strongly favor tougher
reserve mangement and an end to "baby step" rate changes.
These two steps might ameliorate the need to boom and bust
the cash mangement in the system and provide for more
stability in the execution of policy.