Friday, April 4, 2014

The QE Taper, Bank Assets, and Economic Growth

I've been trying to get a grasp on how NGDP and interest rates will proceed as we exit QE3.

Here is a graph of the expected date of the first rise in short term interest rates since the beginning of QE3.  After moving inexorably into the future since the beginning of the crisis, the expected date of rising interest rates finally found a static trend since the beginning of QE3, and has actually moved back in time as the taper has been implemented.  With the termination of previous rounds of QE, interest rate expectations continued their march into the future.  One big current question is, "Will we see that happen again?"  My hope is that banks are healthy enough now to counter any disinflationary effects of the end of QE3.

On the other hand, inflation is as weak as it has been since the beginning of the crisis.  The graph to the right is of the PCEPI and the core CPI - two forms of inflation measurement.  The graph on the left is of 5 year implied inflation expectations from the TIPS spread.

Bank Balance Sheets

Here is a history of total loans & leases, real estate loans, and commercial & industrial loans, expressed as a percentage of bank assets.  I have also shown each series as a percentage of bank assets, net of cash, to show the effect of QE related excess reserves since 2008.

Two things I would note: (1) for total loans & leases and for C&I Loans, the behavior since 2008 looks like normal recovery behavior if we look at them as a percentage of total assets, net of cash. (2) Real estate loans have taken an increasing proportion of bank balance sheets over the past few decades, but they have not begun to recover since the crisis.

The next graph, which shows bank assets as a % of GDP, clarifies these changes some more.  C&I Loans have remained fairly stable as a percentage of GDP, while real estate loans have grown.  Bank assets have grown to accommodate the growing level of real estate values, so the growth of real estate debt doesn't appear to have crowded out C&I Loans over time.  I have added the background relative valuation indicator in order to show how the bank balance sheet expansion was related to low interest rates.  (I speculate that the spike in the late 1970's didn't lead to more real estate expansion because of the exceedingly high nominal interest rates at the time.)

Here is a graph of the nominal level of bank assets since 1973.  They never strayed far from the trend of 7.3% (log) growth over the period.  The next graph shows the nominal level of bank assets in the more recent period, both gross and net of cash.  Since the beginning of QE3, total bank assets have been growing at the long term trend rate.  They aren't catching back up to the previous trend level, but at least they are growing at a typical rate.  But, as can be seen by the level of bank assets net of cash, until recently, all of this growth was due to excess reserves accumulated as a result of QE3.  In fact, since the crisis, bank assets net of cash have barely grown at all.

The next graph compares cumulative changes in commercial bank asset and deposit levels since the beginning of 2008.  I find it interesting that bank asset levels have moved in a contrary direction to QE.  The level of cash built up during each QE period.  And, we can see here that during those times, bank credit tended to flatline.

Between QE2 and QE3, bank assets were growing.  Gross bank assets weren't growing as quickly as they had during QE2, but they were growing.  QE3 caused gross bank assets to grow at a faster pace again, but once again, this growth appears to have come at the expense of bank credit.

The graph after that shows a recent view of C&I Loans as a percentage of bank assets, both gross and net of cash.  It is interesting that when viewed net of cash, the recovery of C&I Loans is very linear and normal looking, and has even surpassed the pre-crisis high.

But, the graph of real estate loans shows a different picture.  There has not been any recovery.  At least, the relative decline in credit leveled off during QE3, as a proportion of assets net of cash.  Very recent weekly H.8 releases from the Fed are showing signs of recovery here, too, but it is still too early to tell.

QE is a shadow bank

I think the best way to interpret this is that the banks were constrained mostly by capital and possibly also by a lack of investment demand.  The Fed used QE to create bank assets without capital.  The commercial banks are operating as they were before the crisis, but with diminished capital.  In addition to them, we now have a "bank of the Fed".  This bank's balance sheet doesn't show up as part of the H.8 report on Commercial Banks, except that the commercial banks hold its deposits, which appear on their balance sheets as "Deposits" which are held by the Fed as excess reserves.  But, the Asset side of the balance sheet for this bank is completely obscured.  Officially the "bank of the Fed" holds treasuries and MBS.  But, the credit created by this bank takes a mysterious path through the stock market, private equity, real estate, and consumption before it ends up at the Commercial Banks as deposits.  Clearly some of this cash ended up in consumption, as inflation tended to move up with each QE.  Clearly it also funded billions of dollars in all-cash real estate purchases, some equity investments, and even some forms of private corporate loans.  But, those details are lost out in the ether.

What Happens Now that the "bank of the Fed" is closing down?

The good news is that the commercial banks are picking up the slack so far.  During the period between QE2 and QE3, they could almost keep total assets growing apace.  Since the beginning of the taper of QE3, total assets has even accelerated a bit.  Growth in C&I Loans is straight as an arrow.  The question is whether the incipient resurgence of real estate loans can gain traction.

If we look at the QE cash and the "bank of the Fed" as a sort of separate entity from the commercial banks, with the banks holding these deposits as a sort of inert middle-man, and we view the constraining factor in credit markets, not as reserves and liquidity, but as bank capital, profitable investment demand, and regulatory and debt overhang issues in real estate, then asset growth among the commercial banks will need to grow to counter the lack of new credit coming from QE.  But, the existence of these reserves should have only a small effect on inflation.  Interest rates could move regardless of what happens with the excess reserves, but not because of some sort of hyperinflation resulting from the mass expansion of these reserves into new credit.

In this view, the main effect of a rise in interest on reserves may be through mark-to-market losses caused by the higher rates.  But, the deposits making up excess cash reserves were never really loanable funds anyway, if the banks were constrained by other factors.  The Fed could choose to unwind them, which would be deflationary, but I don't see any reason why short term interest rates couldn't move up by several percentage points during that process, and I doubt that there will be inflationary pressures if the cash reserves remain in the banks for a while.

The high number of moving parts in this context makes thinking about interest rates through this period difficult.  They can raise the Fed Funds rate, raised interest on reserves, or sell securities, and all of these actions will have different effects on interest rates and the money supply.  I'm fairly confident that at some point the Fed will create another liquidity crisis as real estate tries to reach its higher justified price level again, but I'm losing faith in my ability to figure out interest rates in the 2016-2017 time frame.

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