Friday, May 9, 2014
Normal Interest Rate Behavior
The second graph compares the actual Fed Funds rate to a simple forecast of the Fed Funds rate, using the growth rate of Commercial & Industrial Loans and inflation. The model uses the period through 1990, so the last 24 years are out of sample. Again, this shows fairly predictable movement until recently, with a current forecast rate of more than 4%.
The third graph compares corporate spreads to the Fed Funds rate. If corporate credit spreads continue to decline another 1/2 point or so, they would be where, typically, short term risk free rates would start to rise. Note, that spreads are still fairly wide, despite all the chatter about investors reaching for yield.
Now, there clearly has been a shift in these relationships in the past 5 years, so we shouldn't expect to see perfect co-movement. But, this does point to a potential return to normalcy. I do wonder if some of the recent debate among economists about how increasing interest rates could, counterintuitively, be inflationary, could be on to something in this context. If banks ceased to be strictly capital constrained, and the Fed cut interest on reserves (IOR) to 0% and started selling treasuries, banks would be highly incentivized to convert their cash reserves into credit. The end result of those processes could be expansionary, depending on the relative quantities of Fed assets and bank reserves that ended up moving.
It's hard for me to wrap my head around all the possible ramifications of the current Fed position. It seems like, regarding interest rates as a standalone issue, a lot depends simply on the mechanics of monetary policy chosen by the Fed over the near term. My impression is that they intend to kind of sterilize the excess reserves and slowly reduce them in a way that is intended to have minimal cyclical effects. Please correct me in the comments if anyone has contrary knowledge.
Side note on IOR:
1) I disagree with the notion that IOR is a giveaway to the banks. I see the banks as having an operational balance sheet apart from the items related to the excess reserves. Regarding those parts of their balance sheets, there is some set of competitive forces that is leading to an equilibrium level of total profits. Now, due to Fed activity, the banks have $2.5 trillion in cash, which is earning some minimum level of interest, and they also have an additional $2.5 trillion in deposits, on which they are paying some minimum level of interest. I don't see any reason to expect there to be any significant net gain to the banks from these extra assets and liabilities. If the competitive landscape led to $x profits without the excess reserves, that same landscape should be expected to lead to $x profits with the reserves, plus some insignificant extra profit for the trouble of servicing the accounts. Now, considering where we are, the excess reserves probably benefit everyone to the extent that they represent accommodative monetary policy, but I just don't see the direct transfer of cash to the banks adding up to much.