Larry Kudlow

Fed head Ben Bernanke went before Congress this week with his midyear update on monetary policy and the economy. In so many words, the former Princeton economics professor is taking credit for averting the collapse of our financial system; is cautiously optimistic about economic recovery by year-end and 2 to 3 percent growth in 2010; and says he has the tools and wisdom for a carefully crafted liquidity-exit strategy that will prevent future inflation and more asset bubbles.

Do we believe him? Is he credible? Or is this a triumph of hope over experience?

Before, during, and after Bernanke’s testimony a flood of corporate-earnings reports beat Wall Street expectations, sending stocks into an unexpected summer rally that has virtually beaten the bears into submission. A third-straight rise in the Index of Leading Economic Indicators points emphatically to recovery and an end to the recession. Strong profits at companies like Apple, Caterpillar, Merck, and Starbucks suggest that “someone, somewhere, somehow is spending money,” in the words of Wall Street blogger Douglas McIntyre. Or maybe the Fed’s liquidity mustard seeds are finally germinating.

Yes, nearly 10 percent of the workforce is unemployed. But the other 90 percent who are still working -- along with the companies that employ them -- are out there taking risks and going about their daily chores. Think of them as recovery canaries in the coal mines of the economy.

So I say amen to Mr. McIntyre, which means Mr. Bernanke should be getting ready to implement his exit strategy.

In ballpark terms, the Fed pumped $1 trillion of new cash into the economy to stop the financial crisis last fall. So far in 2009, the Fed’s balance sheet has flat-lined; no new money has been created. That, by itself, could spell the beginning of an exit strategy.

In a much-ballyhooed editorial in the Wall Street Journal this week, Bernanke said that while a near-zero interest rate will be maintained for an extended period, the Fed is on guard to stop potential inflationary pressures. And he correctly noted that most of the Fed’s newly created cash has been deposited by the banks as reserve balances at the Fed itself.

These “excess reserves” are way more than the banks need to keep at the Federal Reserve. And when banks re-employ these reserves with renewed lending, Bernanke says he’ll have a signal to gradually take restraining actions. The Fed can drain the excess cash by selling Treasury securities, or it can pay higher interest on the reserve balances themselves.


Larry Kudlow

Lawrence Kudlow is host of CNBC’s “The Kudlow Report,” which airs nightly from 7 p.m. to 8 p.m.