Last week I observed:
…the RBA will resist cutting rates unless the situation gets really desperate. Ultra-low interest rates encourage risk-taking and speculative behavior, offering short-term gain but courting long-term disaster. Walter Bagehot, editor of The Economist, observed more than 100 years ago: “John Bull can stand many things, but he cannot stand 2%.” Sound economic management requires that central bankers make the hard choices, resisting pressure from commercial banks and politicians.
Total assets of the four major banks grew at a much faster rate than nominal GDP from 2004 to 2014. This was only achieved through rapid expansion of debt in the economy.
The sharp rise in debt pushed households into a precarious position, with record levels of debt to disposable income and a serious bubble in house prices.
The RBA and APRA have used macro-prudential measures over the last few years to rein in debt growth, with some success. The ratio of major bank total assets, mainly debt, to nominal GDP declined considerably since 2015.
This is a major policy success by the RBA and APRA and they are unlikely to want to reverse course. But they may decide to slow, or even for a time halt, the decline in order to prevent a downward spiral in the housing market. Expect total asset growth of the big four to match nominal GDP growth, at around 5.0%, over the next decade. Comprising 3.0% real GDP growth and 2.0% inflation. A far cry from the heady days of 10% annual growth between 2004 and 2014.
Quantitative easing (QE3) ended in the second half of 2014 after the Fed announced it would taper asset purchases in December 2013. The graph below shows that total assets leveled off at $4.5 trillion and have been maintained at that level since.
But the graph also shows that the Fed continues to drip-feed the financial system by running down excess reserves on deposit from a high of $2.7 trillion in August 2014 to $2.25 trillion in August 2016.
Commercial banks are required to hold certain reserves at the Fed but in times of financial stress will deposit excess reserves at the Fed, when trust in the interbank market breaks down. The Fed commenced paying interest on reserves in October 2008 and increased the rate to 0.50% in December 2015. This has encouraged banks to retain excess reserves at the Fed where they earn a risk-free rate of 0.50%.
By raising or lowering the rate payable on excess reserves the Fed can attract or discourage deposits, tightening or easing the availability of funds in the interbank market. Banks have withdrawn $450 billion in excess reserves over two years, which suggests that they can achieve more attractive risk-reward ratios elsewhere. The Fed has not responded, indicating that they are happy for this back-door easing to continue.
Only when the red and blue lines in the first graph converge will the Fed have commenced monetary tightening. That still appears some way off.
I have read a number of predictions recently as to how stocks will collapse into a bear market when quantitative easing ends. The red line on the graph below shows how the Fed expanded its balance sheet by $3.5 trillion between 2008 and 2014, injecting new money into the system through acquisition of Treasuries and other government-backed securities.
Many are not aware that $2.7 trillion of that flowed straight back to the Fed, deposited by banks as excess reserves. So the net flow of new money into the system was actually a lot lower: around $0.8 trillion.
The Fed has indicated they will end bond purchases in October 2014, which means that the red line will level off at close to $4.5 trillion. If excess reserve deposits continue to grow, that would cause a net outflow of money from the system. But that is highly unlikely. Excess Reserves have been growing at a slower rate than Fed Assets for the last three quarters, as the graph of Fed Assets minus Excess Reserves shows. If that trend continues, there will be a net injection of money even though asset purchases have halted.
Interest paid on excess reserves is a powerful weapon in the hands of the FOMC. The Fed can accelerate the flow of money into the market by reducing the interest rate, forcing banks to withdraw funds on deposit in search of better returns outside the Fed. Alternatively, raising interest paid above the current 0.25% p.a. on excess reserves would have the opposite effect, attracting more deposits and slowing the flow of money into the market.
The Fed is likely to use these tools to maintain a positive flow into the market until the labor market has healed. As Janet Yellen said at Jackson Hole:
“It likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after our current asset purchase program ends.”
That’s Fedspeak for “Read my lips: there will be no interest rate hikes.”
Commentators have highlighted the fact that bank excess reserves held on deposit at the Fed — and on which banks are paid interest at 0.25% p.a. — are declining. This would suggest that bank lending is rising, increasing inflationary pressure.
The Fed is well aware of the situation
…and has responded to the recent slow-down by scaling back asset purchases (quantitative easing). They are likely to track the decline of excess reserves to ensure that the impact on the working monetary base (monetary base minus excess reserves) is contained — along with inflationary pressures.