Paris | Why is economic growth so modest in the United States given the low levels of interest rates? Or as Jim Glassman of JPMorganChase (JPM) wrote last week: "According to popular theory, Treasury yields should be much higher than they are, given the current rate of GDP growth."
Remember when regulators talked about a nonsense called "macroprudential" policy? The short answer to the riddle of growth vs interest rates posed by Jim Glassman is excessive regulation. Sadly when we hear from a number central bank officials and economists tomorrow at the Banque de France, there won’t be any discussion from the assembled expertsof a conflict between monetary policy and regulation.
Perhaps the single most oppressive factor in the US economy today is the Federal Open Market Committee. Since the 2008 financial crisis, the FOMC has subsidized the US banking systems to the tune of about half a trillion dollars per year, yet the committee members insist that their policies are intended to promote job creation and economic expansion.
Most of the benefit of lower interest rates have flowed to the largest banks and leveraged investors while the US economy has largely healed itself. Do the math: $100 billion per quarter in subsidies to banks in terms of low deposit rates and bond yields, plus billions more per month paid by the Fed risk free in interest on excess reserves (IOER).
Bank net interest margins shrank dramatically in the past year as market rates have risen, yet the subsidies continue to flow because deposit rates have barely moved. And the sad part is that, even as the FOMC effectively competes with the US Treasury by paying IOER, it is also encouraging banks not to lend to support real economic activity. We illustrated the mathematics of financial repression in The IRA last month (“Bank Earnings & Financial Repression”).
The dirty little secret kept by the FOMC is that were it to actually stop paying IOER tomorrow, the Fed funds rate would probably be cut in half. That would not fit into the macroprudential fantasy that justifies the actions of the Fed over the past decade. Within the strange, neo-Keynesian logic that operates within the US central bank, the FOMC believes that it must use IOER to manage interest rates upward to prepare for the next recession. But by pushing up short-term interest rates when there is so little real demand for credit, the FOMC may actually cause the next recession.
So why does the central bank feel compelled to force short-term interest rates higher? Didn’t the FOMC buy $4 trillion in Treasury debt and mortgage backed securities in order to promote risk taking and investment to boost employment? Well, sort of yes and sort of no. The fact is that demand for short term credit is much weaker than the FOMC is willing to admit. And as we have discussed previously, the FOMC refuses to take losses on the System portfolio by actually selling bonds. Thus, to Glassman's point, there is an effective cap on long-term interest rates.
Even as the Fed was manipulating credit spreads and credit markets via quantitative easing, prudential regulators were increasing capital requirements for banks and discouraging lenders from taking risk. Specifically, bank capital levels have basically doubled since 2008, which leaves less of the bank balance sheet available for lending. We discussed this asset allocation issue with Dennis Santiago of Total Bank Solutions a couple of weeks back (“The Interview: Dennis Santiago on Banks, Blockchain and the Goddess of NIM”).
More important, the supervisory guidance to banks from prudential regulators, in particular the officials at the Federal Reserve Board and the Office of the Comptroller of the Currency, has been to avoid risk taking. Hard ceilings have been placed on all manner of bank loan exposures, from commercial and industrial loans to construction finance and multifamily and residential real estate. As with the increased capital levels, the guidance from US regulators makes it effectively impossible for banks to maintain levels of credit needed to fuel higher economic growth.
In addition to limiting overall bank loan exposures for much of the US economy, federal regulators have specifically limited lending to consumers, particularly the bottom third or so of Americans in terms of credit scores. Roughly one third of all Americans who can actually qualify for a FICO score have score below 650. This puts them out of reach for most bank lenders, especially the largest banks.
Even as the overall credit quality of US consumers has been rising over the past decade, banks have effectively been told to only lend to consumers with credit scores north of 680-700. According to the company formerly known as Fair, Isaac & Co, the average FICO score rose to over 700 last year. The chart below from FICO Blog shows the distribution of FICO scores through 2017 and is republished with permission.
The reason that non-banks have come to control more than half of the US mortgage market is that the depositories were told to avoid any default and/or reputational risks involving US consumers, who are viewed by federal regulators as being toxic. This guidance is not written down anywhere the public may see it, but the effect on credit availability from banks is stifling economic expansion and arguably offsets much of the positive benefit from the FOMC’s manipulation of interest rates.
If all of this seems a little bit crazy, it is. The folks on the FOMC bend the rules of monetary mechanics and more, but prudential regulators have put in place guidelines and unpublished rules that effectively freeze out millions of Americans from getting loans for their new business or to buy a home. If you think that the 2010 Dodd-Frank law was meant to protect consumers, then you’re right. It protects them from gaining access to credit on reasonable terms from federally insured banks.
Of course you’re probably thinking that the non-bank lenders are picking up the slack with less affluent Americans, but not really. Banks may be levered 10-15 times on equity, but non-banks lever their capital just 1-3 times -- if they want to access the investment grade sector of the capital markets. So even if non-banks are willing to lend to borrowers with inferior credit, their ability to support lending volumes is constrained by limited balance sheets.
One reason why lending volumes for the US residential mortgage market have fallen for the past three years is that there simply is not enough capacity to support these less attractive borrowers. More, the Fed’s manipulation of asset prices has pushed the cost of a home beyond the reach of many American families. Meanwhile, the competition among banks and non-banks for loans to more affluent borrowers has driven loan spreads for assets such as mortgages and auto loans down to all-time lows or even negative.
So what is to be done? In simple terms, we need to moderate the oppressive bank regulatory environment to allow banks to lend on reasonable terms to creditworthy borrowers. At the same time, the FOMC needs to realize that pushing up short-term rates much above current levels in the near term is going to be counterproductive and could lead the US down the path to a recession.
There is simply not enough leverage available in the US economy to support higher growth at today's interest rates – especially given the regulatory restrictions placed upon banks when it comes to capital and lending. If we proceed with the FOMC’s planned rate hikes, the proverbial aircraft runs the risk of stalling at the end of the runway rather than taking off. Until we can somehow harmonize regulation of private credit with public monetary policy, this conflict of visions between the FOMC and federal bank regulators poses a serious risk to the US economy.