The Fed, the interest income channel and net interest margins
A few hours ago I wrote a rather downbeat post on the prospects for the US economy that continued the thoughts from an article I wrote in the New York Times. A number of other sources have confirmed some of the logic behind that post since then. The Congressional Budget Office has said that the US taking on austerity by falling over the fiscal cliff next year would lead to recession and that the economy would be weak even if we did not. Sober Look showed us four fiscal cliff scenarios from Credit Suisse. The best case scenario was a 1.0% drag on GDP growth. And Greg Ip at the Economist argued as I did that fiscal agents were going to be contractionary and so, like it or not, it’s all up to the Fed now.
But let me go a bit further in my analysis here, specifically on how Fed policy works through the interest income channel.
In the last post I ended:
My conclusion: The Fed cannot fulfill its mandate in getting the United States to full employment without active policy efforts from fiscal agents irrespective of whether it tries new untested monetary policies. But fiscal agents are working against full employment…
I anticipate federal fiscal policy will become even more contractionary in 2013 when the fiscal cliff is reached. And the US economy will slip into recession – if it hasn’t done so already.
This is where those comments from:
The current economic malaise was borne out of high private sector indebtedness in an environment in which asset prices were falling. The result was what I call debt stress, that is a need to increase savings to pay down debts of underwater assets, mostly houses backed by mortgages. This is what Richard Koo calls a balance sheet recession. And the psychology of the balance sheet recession is a feeling of being trapped and suffocated by debt, underwater assets, high interest costs, and stagnant income.
Early in 2009, the federal government enacted fiscal stimulus to boost incomes. The Fed has also moved against this by lowering interest rates and reducing interest payments to bring back housing affordability. This has certainly reduced debt distress for debtors. But income and job growth remains anemic, in part because of cuts at the state and local level where government is severely revenue constrained. So the stimulus effect has faded.
With rates at zero percent, the Fed has therefore taken to unconventional monetary policy, quantitative easing and more aggressive central bank communications. The thinking here is that the Fed can reduce risk premia and induce shifts in private portfolio preferences that will boost asset prices and capital investment that lead to higher employment. (See here on how quantitative easing really works). But, the economy remains mired in slow growth because these policy tools have not been particularly effective. I have argued then that the Fed cannot save the day.
But what else could or should the Fed do? In the last post, I pointed to permanent zero (signaling that zero rates would be maintained for longer). I also pointed to rate easing (targeting non-policy interest rates). The Fed could always buy up financial assets like short-dated municipal bonds. And finally there’s nominal GDP targeting where the Fed explicitly says it will buy as many financial assets as is necessary for the economy to reach a nominal GDP growth target, whether the added nominal growth is from real growth or inflation. In nominal GDP targeting and in the related policy of relaxing the price stability mandate and going for a higher inflation rate target, the goal is to create enough inflation to pull forward demand and “jump start” an economy short of aggregate demand until companies start hiring people and boosting incomes.
All of these ideas are largely untested fallback options because the Fed Funds rate has reached the zero lower bound. If the Fed Funds rate were 5%, then the Fed would simply cut rates to stimulate the economy. However, over the last two recessions the Fed has cut rates so much that it now can cut no more and must try other untested policies to fulfill its constitutionally-enacted mandate of supporting full employment.
Here’s the thing: the household sector is still highly indebted and the financial system is still undercapitalized. The only reason that these problems look less onerous is because we are coming off a peak in the economic cycle. In a recession, household indebtedness, house price declines and credit writedowns would all come back with a vengeance and produce a toxic mix that would make things quite ugly. The problem is that balance sheet recession thing – an asset price, debt and income mix that lead to debt stress and deleveraging.
Can the Fed do anything about this in the absence of active fiscal support? I certainly don’t believe so. But it certainly can try and many are telling it that it would be irresponsible and reckless not to do so.
The interest income channel and banks
However, this is where the interest income channel and net interest margins come into play. See over the longer term, Quantitative Easing and Permanent Zero are toxic. I have written on this a decent amount before so let me quote the previous posts here. First there are the banks. As I wrote late in 2010:
I am starting to take the view that the Fed is reducing net interest margins. Back in 2008 and 2009, US banks benefited from low rates as their net interest margins were huge. For the first quarter of this year, JPMorgan Chase even had a negative net borrowing rate of interest while it made 324 basis points in net margin. They were effectively paid to borrow, leading to a more than 3% interest rate spread on loans. That’s a great story. Can it last, though?
The short answer is no. As the long end of the yield curve comes in due to either QE or what I have been calling permanent zero (PZ), as zero rates become a permanent state of affairs, interest margins have compressed. Rates will compress even more the longer rates stay at zero percent because the expected future rates will start to come down (see here on bootstrapping the yield curve).
What’s more is that PZ will be a big problem in a Shiller double dip scenario because banks will be set up for huge loan losses despite recent under-provisioning. Meanwhile they will have no way to make it back on net interest as long rates come down in a recession while short rates remain at zero percent, killing net interest margins.
This is the problem with QE and PZ money: it works in the short run, but is toxic in the longer-term. Now if liquidity was the real problem for banks, then the banks will have enough capital to ride through this. They will recover as many did in the early 1990s during the last banking crisis in the US.
If solvency is the banks’ problem, QE and PZ will be toxic.
So, if you follow my logic here, the fiscal cliff and anemic job and income growth equal anemic consumer demand and recession in 2013. That’s because austerity is not about producing short term growth. It kills it. If you back austerity, you have to be honest and acknowledge this as pundits like Hugh Hendry do. People like George Osborne who believe in confidence fairies don’t.
Meanwhile the Fed will probably extend permanent zero to 2015, flattening the yield curve. And that’s bad for net interest margins because if the yield curve flattens and we enter recession because of the fiscal cliff and despite the Fed’s best efforts, banks will have increased loan losses but also reduced net interest margins. This will be a self-inflicted economic wound because the signs of malinvestment excess from extremely low interest rates are all around us. When recession hits, these losses will crystallize. And there will be no steep yield curve to bail out the banks as we saw in in the early 1990s. The banks will have to take it on the chin like the Japanese banks did in 1997 – and we know what happened there.
The interest income channel and savers
Switching tack, lets look at households. Traditionally, people think of rate cuts as stimulative because of the effect on debtors. Interest rate cuts reduce debt payments for businesses and households that cause debt stress and they make it easier for companies to take on more debt to fund capital investment. But when we talk about interest income, its not just about debtors and banks, it’s also about savers. And in periods of low credit demand growth, it is the effect on lost interest income that overwhelms the effect on credit growth. In fact, I would argue that this policy actually helps tip economies into deflation.
In the US right now, demand for credit by what financial institutions deem creditworthy borrowers is not growing robustly enough to act as a credit accelerator. So, the real impact of lower interest rates in increasing nominal GDP is mostly from the lower debt service costs associated with those rates. This is countered by lost interest income for households, businesses and investment companies – which acts as a drag on growth, so much so that people are taking on risk and buying equities or high yield bonds or other higher risk assets – much as the Fed wants then to do.
What happen then in a recession? Ah, recession. This is where “the psychology of the balance sheet recession… a feeling of being trapped and suffocated by debt, underwater assets, high interest costs, and stagnant income” comes back with a vengeance. Suddenly people start deleveraging again and the economy tumbles downward. If the economy tumbles down far enough when inflationary pressure is already subdued, then inflation can tip into deflation as it did in Japan. And then the same people who were concerned about low rates stealing interest income become coupon clippers, knowing that deflation will bail them out. Suddenly, your economy is trapped in a deflationary rut – and central bank policy of zero rates helped to get it there.
My conclusion: the very policy tools people are pushing the Fed to use will have unintended consequences and could be deflationary accelerators unless Fed policy is aided by concrete attempts to reduce private debt, increase household income, write down assets, and reduce shadow inventory. If we do have a recession in 2013 – and I believe we will – then it is likely that deflation will take hold and the US will find itself in a very Japanese scenario.
[Update 2013: Note that the U.S. did not go over the fiscal cliff, which changed my outlook for the U.S. See March 2013’s post “On continued recovery in the US“. The framework remains valid. However, a longer recovery hopefully reduces the need for deleveraging.]
My conclusions are almost identical but for slightly different reasons, I think that the deflationary pressures are already there. As you said households are seriously indebted and with incomes struggling to cope. Asset prices are seriously overvalued and beyond the ability of households to support them. Ultimately that is unsustainable and will collapse. All the efforts by the Fed have been to support asset prices to avoid a flood of foreclosures and fire sales. Slashing interest rates helps cuts the cost of mortgages for the seriously indebted but only delays the inevitable. This would destroy the commercial banks capital and end the US financial system. Home prices will eventually resume their downward trend once the reality has set in for the majority of people. Every policy has been extend and pretend in a desperate effort to maintain current business models. They will fail because they are broken. You can see this by QE being less effective every time it is used. Asset deflation will resume and people will start to wipe their debts out through bankruptcy. This will clearly impact the overall economy.
Savers are being hit by the loss of income and the impact of low interest rates are destroying pension incomes and longer term the rational for even saving in a pension. Pensioners are being forced to take greater risks ,a s you commented, to get a decent return to retire on. So when the next financial crisis strikes, which will be soon, they will be wiped out financially, because they were in high risk assets rather than the low risk assets that they should have been in.
The solutions will not be considered until it is too late. There needs to be serious re-regulation of the financial sector and actual regulation from regulators. Somehow I suspect that the US zeal for deregulation will be mean that they will not be in place and that the US may suffer for longer than many other countries. To be fair the UK has the same problems and even further to go to repair its national and personal balance sheets.
There is a silver lining to this outcome. Once the collapse has happened most of that debt burden will be wiped out and then any Keynesian fiscal stimulus will be actually effective. Without a debt burden any stimulus will actually get through and work, rather than being drained off by banks. The only problem is that Congress may get cold feet and stall any recoveries just as in 1937 by trying to cut the deficit too early.
There could be measures to assist but cram downs will be blocked and I suspect that the only thing that Congress will be able to do is reform bankruptcy. As for a US recession next year that may happen anyway even if the fiscal cliff is avoided completely and no net cut happening to government spending. The states are still cutting and with the euro in crisis exports will suffer and so the prospect for business will suffer. Unlike the thirties when there was real risk of a rise of communism in the US that prompted the creation of new agencies to spread the wealth to workers there is no external pressure this time so action may be much slower.
I think another way of expressing what you are saying has to do with malinvestment. Essentially, long term ZIRP begets malinvestment, which serves to further exacerbate a balance sheet recession.
As you say, “Pensioners are being forced to take greater risks ,a s you commented, to
get a decent return to retire on. So when the next financial crisis
strikes, which will be soon, they will be wiped out financially, because
they were in high risk assets rather than the low risk assets that they
should have been in.” That’s the crux of it. Capital going to places it shouldn’t, further building imbalances. That’s why at the end of the day, the Fed has to walk a very fine line and not overplay its hand. And on the fiscal side of things – government can provide Kensian stimulus for a while, yes, but unfortunately, it is the biggest malinvestor of all. It’s been running $1+ trillion deficits for years now with not a whole lot to show for it. Somehow the private sector has to be shaken out of its rut. Unfortunately, people tend to overestimate these two players ability to do that (be it because of inherent limits to their power or because they tend to make mistakes in pushing the right levers or applying them for too short/too long; and the longer a crisis lasts, the more “chances” there are for mistakes to take place).
You have hit the nail on the head. Well said.
Isn’t that exactly what Minsky said, 30 years ago?
Minksy, Hayek and Keynes all saw the merits of recessions which governments ignore. Politicians hate recessions because they interfere with re-election.
Yes we both agree that ZIRP is creating poor investment options. I would prefer a policy of cap and collar for interest rates to stop such abuse. Then government needs to act to either cut or raise spending or taxes to boost or cool down the economy. Fiscal policy has been ignored as a regulator of the economy.
If you check I did say Keynesian spending AFTER the debt clear out. As for Government being the biggest mal-investor of all I would challenge that generalisation. Yes as the biggest spender of all it will be but then look at business it makes collectively even more malinvestment, so was the housing bubble a government problem? No it was a problem of the private sector and the banks. If you look at Scandinavia where government is a bigger share of the economy there is no anti government hostility because they are efficient in using that money. In the US that is not the case. As for the Fed they are like a trade body who are doing everything to protect their members even if it kills the economy.
As for the deficit, much has gone to the military which is the least efficient way of spending it. Government is not the problem, it is the people that you put in charge that are the problem. The US political system is endemically corrupt, and that is the root cause of the bad spending choices. Plus if a politician is ideologically against government he/she will not put it right they will allow any problems to grow to support their reasoning.
Let me clarify a bit… true, government is not necessarily a big malinvestor, BUT, the US govt. specifically, is. The examples are boundless… like as you mentioned for example the military. Keeping a military meant to BOTH fight the Warsaw pact AND low intensity conflicts where the first threat has been completely removed is ridiculous. Also, instead of doing a true giant infrastructure package aimed at those areas where we have serious infrastructure deficiencies, it spent money bailing out insolvent banks (which are still insolvent). Even in the housing market it has had a heavy hand by allowing Freddie and Fannie to participate in the credit quality race to the bottom during the bubble AND continuing the travesty which is the leverage building in the FHA today. So, for all practical purposes maybe the US govt. isn’t the biggest malinvestor, but it sure is right up there with the rest of the big boys, and, it has setup the regulatory framework (or lackthereof) and implicit (and sometimes illegal) guarantees through which the private sector is encouraged and enticed to malinvest. I do though fully agree that it is not government per se that’s at fault, it’s that at the end of the line, it’s us the citizens who keep voting for the clowns at the top who are ultimately at fault.
It’s interesting to point out that on a long term basis, BY FAR the greatest threat to the US economy is outsized medical costs which add up to the tens of trillions of dollars in future (and unfortunately, mostly unrecognized) obligations of both the US govt. as well as private businesses which are uncompetitive compared to businesses in other countries because of how much they have to spend on healthcare comparatively. Here is a beutiful example where the US govt. is a huge, giant, gargantuan malinvesotr – by NOT constructing some sort of universal coverage framework that leads to cost containment in the medical field. Essentially every other developed country has realized that they best way to contain cost while delivering reasonable care is by having the government be the “investor/funneller ” that essentially controls the entire system and keeps costs down. At least if the high costs of our system could be shown to deliver better outcomes than other healthcare delivery and funding models (which achieve the same or better results at half the cost) then you could see some merit to the US system, but it unfortunately it doesn’t.
So, here in the US were DOUBLY screwed. In those areas where the goverment’s heavy involvemnt is highly beneficial to a national economy, the US government is absent and in other areas where government is “known” to be usual suspect malinvestor, we get more of our fair share. This is both unfortunate and disturbing at the same time.
The corruption of US politicians is one reason why the US will have significant problems. The problem is that the system keeps out honest politicians because they need funds to get elected. Dishonest politicians will be able to get the funds from lobbyists and those that want the law changed to benefit them. Until that link is broken I have little faith in the US being able to get itself out of this mess. In fact with people like Paul Ryan and Mitt Romney I actually suspect that they will take advantage of this to push their own special interest agendas. For example they could ban federal funded abortions to ostensibly save money. I could show brilliant US government funded programs such as NASA which for a fraction of the funds spent elsewhere has achieved incredible results. It is not government that is the problem but the people running it. So yes voting for clowns does mean that you want those circuses.
I agree with you about the state of the big 22 US banks. They are insolvent and the problem is that the Fed has impaled the tax payer on to the liability hook to bail out the banks. The community reinvestment act was used by banks as a reason why they had so many sub prime loans on their books. It was because they used minorities as piggy banks to fund white customers lending elsewhere that the law had to be introduced. Now where would an act state that they had to make stupid loans just to be racially diverse. Yet that was rolled out as one reason why US banks had a sub prime mortgage problem. It was simple racism.
As for US healthcare costs, Obamacare does actually make a step in the right direction. Though a single payer option should have been an option. It would have given the US consumer a much needed break to their wallets. So if you have unlimited funds then it is does give you the best care in the world, but only if you can afford it. Otherwise it ranks for most Americans as almost third world level, with tens of thousands dying because they have no insurance or their provider does not cover their condition.
The defence problems with aircraft like F35 not being able to fly and costing $250 Million each is down to mismanagement and fraud by the contractors. Though with the government targeting whistleblowers right now they deserve the mess that this is causing. A whistleblower would have saved the government hundreds of millions.
You have the crazy situation where you have private prisons and they fund politicians to create new laws to put ever more people behind bars, at the tax payers expense. There needs to be a ban on any company getting any government money lobbying or paying any politician. That is simple corruption.
Add in the necessity of congressmen and women to pork barrel to show that they are doing something for their constituents, and you have a built in incentive to go corrupt and go big at the same time. End this influence and you can have good government. Yet the US is a long way from that.
Let me second Rob’s comments here. I think the way he puts it is spot on. The government, particularly the Fed, is trying to sustain the unsustainable by severely distorting incentives in the economy. They are trying to get investors to take on risk by keeping rates artificially low and getting them to move into risky financial investments. And they are trying to get businesses to take on risky capital investment too.
Janet Yellen has admitted this and she recognizes the risk (pun intended) of this policy mix. But she feels the Fed must do it.
This is the creation of distortion and malinvestment in the hopes that it will keep the economy going long enough to drive the cyclical recovery into high gear. But if the recovery peters out into recession despite the Fed’s efforts then as I said above the very policy tools people are pushing the Fed to use will have unintended consequences and could be deflationary accelerators.
All of this is putting the cart before the horse, trying to pump up the economy before the debts associated with the previous binge have been worked down. I’s a recipe for disaster.
The problem is that I doubt that they can wait long enough for the cyclical recovery to get into gear. Look at Japan, twenty years and they are still waiting. If they really appreciated the problem they would have taken a different path years ago.
As to the creation of new mal investment it is only the extension of the previous bubble. The deflationary pressures were there all along, just stalled by Fed policy. It is not a consequence of the policy. It is simply extend and pretend on the old policy. They will look identical though to your “unintended consequences”
The problem is that no one is dealing with the cause of these problems just the symptoms. This is still a banking crisis which needs reform and that is simply not happening. So we will have another banking crisis very soon and be back to square one. So while many economists compare this to 1937 and trying to balance the deficit, it is closer to 1930 with all the bankruptcies ahead of us still.
Yes, the last paragraph is exactly what I have been saying for four years. The debts need to be cleared before any attempts at stimulus. It just drains the Fed and government of firepower, for once the debts are really are cleared.
“The solutions will not be considered until it is too late.”
Reality is that, if new voters coming on-line don’t immediately & forever abandon the GOP/DEM party system … everything those political clowns do will be too late for our country, and our future generations. To get more agile policy, we need a more agile electorate.
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