Monetary Policy Cannot Dictate Credit Conditions Forever

by: Martin Lowy


Credit conditions have two components: the risk-free rate and the spread over the risk-free rate.

A central bank can control the risk-free rate but not spreads.

Spreads may narrow for a time (a positive economic force), but not forever.

The credit cycle has turned from a positive to a negative economic force.

Credit conditions have two components: (1) the base, or risk-free, rate, and (2) the spread over the risk-free rate at which the lending community is willing to lend to a particular borrower at a particular duration. It often is overlooked that the two components react to very different stimuli.

The Fed or any central bank can, within reasonable parameters, set the short-term risk-free rate. The market sets the spread over the risk-free rate on each loan based on its assessment of the likelihood that the borrower will repay the loan in accordance with its terms. When the central bank sets the risk-free rate at a low point, it can stimulate lenders to seek additional yield by taking greater risk. Spreads on riskier loans therefore contract, as lenders compete to take risks. The central bank intends that to promote economic activity. That is the process that occurred when the Fed lowered the risk-free rate to near zero in 2009 and pledged to keep it there for an extended period of time: Spreads on loans rated in all categories narrowed.

QE followed in 2010 and thereafter in the form of the Fed buying longer-dated but still credit-riskless securities, which tended to compress the yield curve by lowering the natural premium for longer-term lending.

So far good. Maybe.

Eventually, a time comes when the riskier securities begin to show their risk characteristics. This is when the up part of the cycle of economic activity, that begins when the last recession ended, begins to turn downward, as it inevitably must do some day. At that time, which I would argue was around the end of the third quarter of 2015 (though there is evidence to suggest an earlier date), the credit risks are taken more seriously by the lending community, and the Fed and other central banks are without power to prevent risk spreads from widening or to force the lending community to roll over the riskier loans.

The new process results in defaults and in the contraction of economic activity. And as I said, the Fed and other central banks are powerless to entice the lending community to take the additional risks without vastly greater compensation by way of spread over the riskless rate. And the vastly higher interest rate that the lending community demands of the riskier borrowers cannot be afforded by those borrowers, whose businesses, by definition, are not performing as had to be anticipated to justify the risks that lenders were taking. Lending to such borrowers grinds to a halt, regardless of how low the risk-free base rate may be.

I doubt that negative risk-free rates can restore central banks' power in this regard because the risky borrowers still will be in process of becoming riskier.

This process is what now is forcing the global economy to slow. It does not appear that conventional central banking can reverse the process until large amounts of bad loans have been recognized and washed through the bankruptcy system. That process hurts banks and all other lenders, including individuals and their retirement funds. It has to take some time.

There is much more to this story. I have written a longer version that includes data to show how spreads and credit ratings have changed over the last six years and where we are in the credit cycle in February 2016. But I have not put any data into today's little explanation because the process is so clear, and readers will, I hope, focus on the simplicity of the theory. The article with data will come in a few days.

I also intend to follow up with a discussion of misallocation of resources (I like that term better than malinvestment) that the low rates probably caused. That appears to be an important part of why inducing lenders to take greater risks does not work for the long term. But that is another fairly complex story that I do not want to interfere with the simplicity of the theoretical framework.

So, commenters, please have at it on the usefulness of the theoretical construct.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.