A Convocation of Interventionists – Part 1

St. Louis Adjusted Monetary Base

In a way this is quite funny, since the central bank’s policies are the root cause of the crises during which it is now supposed to provide “stability” by crowding out the private sector (!). As noted above, we never doubted that the plan to shrink the balance sheet would be scrapped one day. We just have to wait for the official announcement now (although we expect the pretense to be kept up for a while yet).

The chart below shows the monetary base, which we use as a proxy for the Fed’s balance sheet (mainly because this allows us to provide a very long term view). The times when the Fed’s balance sheet was deliberately reduced are few and far between. Endless expansion is the norm.

Adopting this proposal would also mean that the debt monetization under the Fed’s QE programs would ex-post become true “helicopter money”, as the monetization of this debt would then become officially and explicitly permanent.  Perhaps no such announcement will ever be made, but the balance sheet will remain bloated anyway (as e.g. happened after the massive expansion during WW2).

Boosting Credit Expansion

Another paper pondered the possibility of lowering the interest rate the Fed pays on reserves, as an incentive for banks to boost credit expansion. According to Reuters:

“The Federal Reserve could push banks to lend more by paying Wall Street smaller returns on money stashed at the U.S. central bank when inflation is low, according to an academic paper presented on Saturday.

The proposal was one of several discussed at an international gathering of central bankers who are looking for ways to stimulate economies even after they have cut interest rates to near zero and flooded banks with money. In his paper, economist Ricardo Reis put forward a new way for the Fed to pay banks returns on the money they keep at the central bank, a tool that could potentially put the Fed’s goal of keeping inflation at 2 percent on autopilot. Banks currently have about $2.6 trillion at the Fed, a trove that swelled during a massive Fed bond-buying campaign aimed at fighting the 2007-2009 recession.

The Fed currently pays 0.5 percent on reserves, which some critics view as a giveaway to banks. The central bank uses that rate as a way to keep the rates for overnight interbank borrowing from going beyond its target range, relying on reverse repo operations to set the floor. But under Reis’s proposal, the Fed would also use the reserves rate as a stimulus mechanism, indexing its payments to the inflation rate. That would give banks an incentive to lend when the economy is weak and prices are rising more slowly.

The very premise that economic growth is dependent on “inflation” (= rising consumer prices in this case) is already misguided. It is inter alia based on the more general fallacy that spending and consumption are what drives growth. Interestingly, all these positivists seem to have completely forgotten the 1970s.

More likely empirical evidence that doesn’t fit the currently popular narrative is simply ignored. This is also suggested by the Fed’s re-adoption of the Phillips curve, which was recently mildly criticized in the WSJ as a “theory without proof”. Suffice it to say that the Keynesian adaptation of the original Phillips curve “works” about as well as a coin flip.

Loans and Leases in Bank Credit

The idea to spur bank lending in the US by means of lowering interest paid on reserves (IOR) is not exactly a new idea. There is a technical problem though: once reserves have been increased to such an extent that the federal funds market is no longer relevant, IOR is the only way for the Fed to raise its FF target rate and keep (more or less) control of it without shrinking its balance sheet (see above – selling assets is not on the agenda).

It is true that that IOR represents a subsidy to banks, in fact quite a substantial one, but that cannot be helped if the central bank wants to proceed as suggested.

It is also not obvious that such a step would achieve anything, even from the perspective of those who think credit expansion ex nihilo is desirable. The ECB and the BoJ have not only lowered their deposit facility rates to zero, they have driven them into negative territory. These measures have failed to boost lending, while imposing sizable costs on both commercial banks and savers.

Meanwhile, it is not clear why US credit growth should be boosted at all – it is already at dangerously high levels:

Loans and Leases in Bank Credit – click to enlarge.

Growth in bank lending is no longer accelerating, but has fluctuated in a fairly high range of 7.7% to 8.1% for quite some time. Loan growth at the peak of credit booms was previously higher, but these peak levels were usually very short-lived (the persistence of 10%+ growth rates during the 2003-2007 housing bubble was an exception).

Commercial and Industrial Loans

As far as we can tell, the only reason why the current credit boom has not (yet) attained peak loan growth rates similar to the past has absolutely little to do with monetary policy, which is undoubtedly more than loose enough.

Rather, it is due to the fact that private banks can no longer compete with the taxpayer-subsidized state-run mortgage factories (i.e., Fannie, Freddie and the FHA). Since bonds issued by the agencies are guaranteed by the US treasury, they have no problem finding buyers for them. The substantial risks this involves are nowadays borne by taxpayers instead of banks.

One of the main buyers was incidentally the Fed in the course of its QE programs  – and it keeps replacing bonds that are maturing.

As a result of this, mortgage loan growth at banks remains quite subdued. The fact that total bank credit is rising at such heady annualized rates despite this fact is actually cause for concern. To replace the no longer profitable origination of mortgage loans, banks have opted for massive lending to corporations, i.e., credit risk has simply migrated to a different sector. Below is a long term chart of total loans and leases in dollars and cents:

Indexed Price Performance: 1-Year

It can be inferred that a lot of capital has been malinvested in the course of this lending spree. This is rather obvious in the energy sector and other commodity-producing sectors, which continue to suffer large debt defaults. Meanwhile, many companies have decided to engage in financial engineering, but the strategy no longer seems to be working as intended.

The sum of share buybacks and dividend payments by S&P 500 companies has recently reached a new record high in dollar terms. It also exceeds their operating profits since Q1 2015. As of Q1 2016, 146 S&P 500 companies have spent more than their net earnings on buybacks alone over the past year, and at 135 of them buybacks have exceeded free cash flows as well.

Ironically, the S&P “buyback index” has significantly underperformed the overall index over the past year (in mid June the year-on-year performance gap amounted to a quite large 8.6%). The stocks of several of the biggest buyers of their own shares have been among the worst performers in the big cap arena. Investors may finally be getting worried about deteriorating balance sheets rather than being pleased about shrinking share counts.

As we have pointed out in our most recent discussion of US economic data, the ratio of spending on capital vs. consumer goods production likewise suggests that  capital malinvestment is a festering problem. In short, the idea that the central bank should goose bank lending further just because “inflation is low” appears to be particularly ill-advised at this juncture.

Click here for Part 2, which discusses proposals on deficit spending, negative rates and the revived “war on cash”.