The Federal Reserve has been on a bond-buying spree since the start of the financial crisis, trying to flood the economy with cheap money. The Fed is currently buying $85 billion worth of Treasury and Mortgage-backed securities each month to help stave off deflation and accelerate economic growth. While the Fed’s action is just one of many reasons the S&P 500 is up more than 14% year-to-date, it hasn’t had the intended effect on the U.S. economy. Here is why:
Companies, especially banks, have been hoarding cash since the financial crisis in 2008. Banks have been worried about a repeat, being caught with too few reserves and too much toxic debt. Thus, instead of flooding the economy with cheap cash, Quantitative Easing has only flooded balance sheets with cash. The vast majority of the money has not been lent out, essentially blocking the money from reaching the broader economy and accelerating economic growth, which was the primary goal of QE. The monetary base has swelled from $800 billion before the crisis to nearly $3.4 trillion now. However, consumer loans at commercial banks have gone from approximately $800 billion to $1.1 trillion during the same period. Because of this, the velocity of money, or how fast money moves through the economy has decreased significantly. Money has slowed as banks hoard cash in their vaults, waiting for a signal that says it’s okay to lend to people and companies they aren’t currently lending to.
How to Increase Lending
So what will shake some money from the banks’ branches and make them begin lending more? One way would be for the yield curve to steepen. The yield curve is the difference between the short rate and the long rate. Banks will borrow the short rate and lend at the long rate and keep the difference as profit. When the difference between short and long-term rates is negligible, the banks have little incentive to lend because the potential profit does not outweigh the risk. The Fed kept the pedal to the floor with their stimulus, holding the short rate near 0% since 2008 and going through three iterations of its buying of long-term bond purchases. This flattened the yield curve causing lending to drop and slowing the velocity of money.
The Fed’s policy made financial asset prices rise, lifting home prices and confidence. However, their policy may have stunted economic growth by keeping the long rate down and causing banks to hoard cheap money until it becomes more profitable to lend. A real-life example of ending an asset purchase program can be seen in the UK. They ended their asset purchases in November, 2012. Since then, the UK’s government yield curve has steepened and most economic indicators have accelerated.
Regulation and Legislation
Since the crisis in 2008 new regulations have made operating a bank more difficult and expensive. The U.S government went after the largest four banks, Citigroup, JP Morgan, Bank of America and Wells Fargo. These big four plus a couple smaller banks agreed to a $25 billion mortgage wrongdoing settlement in February 2012 and another $20 billion in January of this year. Mortgage settlements at Bank of America alone are near $50 billion. Additionally, circumstances affecting credit approvals are certain aspects of the Dodd-Frank Wall Street Reform Act of 2010. In January of this year, the CFPB (Consumer Financial Protection Bureau) released the mortgage lending guidelines scheduled to go into effect January of 2014. Some of the restrictions are: 1) a borrower may not have a debt-to-income ratio greater than 43%, 2) fees and points may not exceed 3% of the loan amount, 3) lender’s must verify a borrower’s income and 4) no mortgages greater than 30 years and no interest-only or negative amortization loans. These are just a few restrictions banks must adhere to, ultimately making it harder to lend and borrow.
Let the Rates Rise
As I’ve previously written, many investors fear the end of the QE program, but they shouldn’t. The policy, while playing a part in boosting financial asset prices, has not had the effect of accelerating the velocity of money and accelerating economic growth. The end of it could very well be a bullish event. It’s time to let the free market decide where rates should be and there is little doubt that will be higher than where they are now. And that’s not a bad thing. By letting the long-term interest rate rise, the yield curve will steepen and give more incentive for banks to loosen their grip on the record amounts of cash they currently hold on their balance sheets. This in turn should cause growth in the economy and ultimately lead to job creation and a sustained economic recovery. Many have warned that the Fed’s actions, by taking away the market’s ability to efficiently price the cost of money, was, on net, acting as a drag on the economy. Their actions have also encouraged retirees to seek yield from riskier assets, exposing their portfolios to more volatility than they should take on.
Putting it All Together It’s impossible to see what consequences the Fed’s actions since 2008 will have in the long-run. There are usually unintended consequences when something unprecedented occurs, and the Fed’s actions since 2008 have been exactly that, unprecedented. But in order to open the spigot and let all that cash work its way into the economy, banks need to start lending more. The ending or at least tapering of QE may just be the event that finally lets the cash flow freely.
by Mitch Zacks, Senior Portfolio Manager. Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A in Analytic Finance from the University of Chicago. www.zacks.com
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