The Fed can start by raising short-term interest rates, currently near zero, while leaving QE3 on hold. Because the overnight policy rate is unambiguously under the Fed’s control, the Fed should announce a schedule of slowly phasing in higher short-term rates that would end after two years, when rates reach some modest upper bound of, say, 2%.
The current constraint on the supply of loan finance, which arises when nominal rates are near zero, would then be relaxed. Commercial banks with huge excess reserves would start lending them out for a modest return. With short rates even moderately greater than zero, the near-moribund interbank market would spring back to life as a needed backstop for commercial banks’ extending their credit lines to nonfinancial enterprises large and small. Money-market mutual funds would no longer fear “breaking the buck”—seeing their net asset value drop below $1 per share—when they accept short-term deposits.
After a year or so, when the new program achieves credibility, but before reaching the 2% end point, the Fed could return to the problem of tapering QE3. We now know that merely stopping the central bank’s bond-buying program—as initially suggested in Mr. Bernanke’s May 22 tapering speech—with future short-term interest rates being uncertain, leaves bondholders with no idea of what the equilibrium long-term bond rate will be. (I assume that simply leaving short rates at zero is not credible, if only because it does so much damage to the financial system.)