Fed Normalization Possible; Non-Banks Adding Liquidity

Wednesday’s Wall Street Journal front page has an article on non-bank lending to traditional banking areas. “He figured a bank would put him through weeks of aggravation, then reject him. He turned instead to one of the nonbank, short-term lenders that have been gaining traction

…” 

We think Washington’s combined monetary and credit/regulatory policy has been contractionary, helping explain the very weak recovery. 

• The zero-interest-rate policy was paired with tight regulatory policy. This left private sector credit growth weak throughout the expansion. By setting the price of credit low and then limiting the availability, it imposed de facto credit rationing, squeezing out small- and new-businesses and lower-quality credits in favor of loans to government and big business (see Near-Zero Rates Are Hurting the Economy, Dec 4, 2009 WSJ). 

• The Fed’s bond-buying worked in the same direction. By borrowing short-term to buy long-term MBS and Treasuries, the Fed has caused a dramatic shortening of the effective duration of the national debt. To make up for the reduction of duration, the private sector has increased the maturity of its issuance (through corporate bonds, etc.) This favors larger businesses. In effect, the Fed has pushed the government’s large debt issuance into the short-term debt space traditionally available to small- and new-businesses. 

As a result, the mix of commercial bank assets has shifted dramatically toward a barbell configuration. 

• The Federal Reserve is forcing commercial bank assets into short-term loans to the Fed through the buildup in excess reserves (it buys bonds from banks, paying with excess reserves, so bank assets shift from small-business loans to short-term loans to the Fed). Meanwhile, the overall bank balance sheet is constrained by regulatory and litigation problems, leverage ratios, risk-weighted capitalization requirements, etc.

• This has caused a barbell in the maturity of the banking system’s assets, with a heavy weighting at the short end ($2.4 trillion in loans to the Fed) and a heavier-than-normal weighting at the longer maturities (corporate bonds, mortgages, etc.) With the Fed promising a low Fed funds rate for a long time, banks are able to treat long-duration assets as being safe. A Bloomberg story today describes a big new team at Wells Fargo seeking to generate non-qualified long-term mortgages that would be held to maturity. 

• With bank assets constrained and the Fed’s monthly credit demand always met first, this leaves less room on the bank balance sheet for small-business loans. Non-banks are filling the void with short-term, higher-risk loans as described in Wednesday’s WSJ article, but it takes time – through business development companies, leveraged lending, pawning, payroll lending, factoring, unitranche lending and a wide variety of other lending practices. Meanwhile, growth in private sector credit was a slow 4.2 percent year-over-year through the third quarter and M2 money supply has slowed to 5.3 percent year-over-year. 

How can the Fed normalize? 

The monetary/credit policy has been contractionary over the long-term as well, limiting real GDP growth to roughly 2 percent per year and credit growth to only 1.3 percent per year (annualized rate from Q3 2009 to Q3 2013). Today’s minutes from the Fed’s December 17-18 meeting noted that “a majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue.” We think that is being generous and that growth would have been faster if QE had ended earlier. After waffling on a taper in mid-2013, the Fed announced a January 2014 reduction in its bond purchases and got a very positive market reaction. 

• We think Fed consideration of rate hikes (not there yet) would get the same response as the taper talk – consternation in markets followed by acceptance and embrace. Forward guidance is damaging markets now – how can the Fed promise or project a future rate? We think hints of rate hikes would turn out to be stimulative in the same way the taper is stimulative – by moving Fed policy toward normalization. Market-based pricing of assets depends heavily on discounting future cash flows, a calculation that is heavily distorted under current policies. It is clear that markets would function better if interest rates were above zero, including interbank markets, the Fed funds market and money market funds. The Treasury bill rate has been occasionally negative in recent months even though nominal GDP growth is 3.4 percent year-over-year, evidence to us that Fed policy is causing massive, harmful market distortions and uncertainties.

If growth picks up in 2014, helped by non-bank lending, we think there will be a small gapping upward in the effective Fed funds rate, like when a market moves from the buyer to the seller or from the bid to the ask. The effective Fed funds rate is currently at 0.1 percent. A first step in normalization would be to allow it to move to the high end of the Fed’s 0-0.25 percent range. As with the taper, the earlier the Fed moves interest rate expectations toward normal, the better for growth and for markets. Of course, resistance will be ferocious as it was with the taper and with the Fed’s first rate hike in 2004. 

• In the 2004-2006 period, the Fed was able to hold the Fed funds rate well below neutral by allowing a rapid expansion of liquidity through the leveraging of banks and non-banks. Starting at a 1 percent Fed funds rate in mid-2004, the Fed limited interest rate increases to 0.25 percent each six weeks even though the economy and credit outstanding were booming and the dollar’s value falling. The Fed didn’t have to “inject liquidity” by buying Treasury bills to hold the Fed funds rate artificially low. Instead, it used rapid growth in private sector credit to provide the liquidity needed to hold the yield curve down. We think this balance between an artificially low Fed funds rate held down by a gradual relaxation of constraints on private sector credit growth to provide liquidity is a model for the normalization in the next interest rate cycle. It is not ideal, as shown in the 2000s by the housing bubble and the downturn in real median incomes – but it may let interest rates rise gradually even as the Fed’s balance sheet contracts. 

• We expect a major expansion of the Fed’s reverse repo program and think it will help with normalization. Today’s minutes from the Fed’s December 17-18 meeting reported on the successful testing underway. “The staff … in January would likely recommend a continuation along with possible adjustments to program parameters that could provide additional insights into the demand for a potential facility and its efficacy in putting a floor on money market rates.” We expect the Fed funds rate and money market rates to rise marginally as the Fed expands the reverse repo program (see Fed Tools To Affect Short-Term Credit Markets on Dec 16, 2013.) The reverse repo program will give the Fed the ability to shift its liabilities from excess reserves to reverse repos which have a broader universe of lenders that includes Fannie and Freddie. The European Central Bank already makes heavy use of its 7-day term deposit facility. We think the Fed will lower its borrowing cost from the current 0.25 percent rate it pays on excess reserves, make clear its ability to hold bonds to maturity without realizing losses, and improve the functioning of short-term credit markets as the program expands. 

David Malpass is the President of Encima Global and a contributor to e21.