Many investors have been clamoring for QE3 due to a lack of readily available capital in the market as banks have become more cautious and more focused on deleveraging. A program to induce lending helps solve the problem of capital availability and increases the velocity of money without dramatically increasing inflationary pressure by adding more capital to the system. In essence, an inducement program works to use the money already in the system more efficiently by freeing up capital supply to meet demand.
Demand for Lending
Some commentators have recently argued that an inducement policy by the Fed would be both more aggressive and less effective than QE3. To the first point, it is very clear that it is not more aggressive in terms of adding inflationary pressure or growing the Fed balance sheet. Therefore, it will come under far less political fire. The efficacy issue is potentially more serious due to speculation that the lack of lending is not a matter of banks being unwilling to supply borrowers; it is a lack of borrowing demand.
The demand question was largely answered in the Fed's July 2012 Senior Loan Officer Opinion Survey on Bank Lending Practices. This survey indicated that loan conditions to both businesses and households are tighter than the moving average since 2005, but demand is rising due to the inability of European banks to provide loans during their ongoing crisis. The Fed survey indicates:
Regarding loans to households, reported changes in standards were mixed across loan categories, while demand increased somewhat. Lending standards over the past three months were little changed, on net, for prime mortgages and tightened somewhat for nontraditional mortgages. However, a relatively large fraction of respondents reported having experienced stronger demand for prime mortgages over the same time period.
In other words, banks are seeing rising demand. As a result, they are maintaining tight lending standards for prime mortgages, and even tightening standards for sub-prime or nontraditional mortgages. This is the opposite of what the economy needs when it comes to increasingly liquidity and managing the excess supply in the housing market. Further, it demonstrates that banks are sitting on large reserves rather than lending the money out as the Fed intended.
Given this survey data, it is clearer than ever that the something needs to be done to spur lending and increase the velocity of money in the U.S. economy. Since fiscal policy is essentially stalled, the onus falls to the Fed and Chairman Bernanke once again.
In his attempt to spur increased lending, Bernanke essentially has two possible instruments at his disposal, but both float very close to the fiscal policy realm. The first is a simple decrease to the rate the Fed pays on bank reserves. This would reduce banks' ability to make a return simply by sitting on cash, and would, therefore, induce them to lend more freely as they seek profits.
This proposal has major drawbacks, however, as banks may take a short-term loss before they increase lending, and it has the potential to have a detrimental effect on the short term money markets. Chairman Bernanke himself has expressed concern about the impact of such a policy on money markets.
The second possibility is a more complex plan to induce lending, and it looks more like the British "Funding for Lending" program that Chairman Bernanke expressed interest in tracking during his June press conference. Given Bank of England Governor Mervyn King's August 8 comments indicating that the BOE will not cut rates further, initial indications suggest that Funding for Lending might be having the desired effect in Britain. This makes it more likely than ever that we will see a comparable policy in the U.S.
However, it is not completely clear what an American version of this program would look like. It would probably involve a joint venture between the Fed and Treasury. The focus would be on boosting bank lending to non-financial businesses and households by lowering the cost of funding for banks that engage in that lending. This would be coupled with incentives for banks to lend in order to increase liquidity and access to credit by those that need it, without engaging in further asset purchases by the Fed.
While such a plan would ostensibly force monetary and fiscal policy to finally complement rather than oppose one another, such a plan is not without problems. First, a partnership between the Fed and Treasury means that the policy could have federal budgetary implications and questions about the Fed overstepping its mandate by engaging in fiscal policy. The second problem comes from our political timeline. If we have a new administration entering office in January, this will create doubt that any existing Fed-Treasury policy will carry over with new Treasury officials. The third and potentially most troublesome set of problems arises from the demand-side. Banks do not lack borrowers seeking funds, but they may lack worthy borrowers. This problem could be solved if banks loosened their definition of a qualified borrower, but this must be done judiciously, because that is how we got into the crisis to begin with.
More importantly, for such a plan to successfully free up capital on the scale required to boost markets, the mortgage finance sector would need to be specifically targeted and the securitization food chain would need to resume in much the same way it did before the crisis. While the Treasury would initially be absorbing the losses in the system (as they did with TALF), the real goal here is to get collateralized debt back on the secondary market to free up capital in at least one key sector of the economy.
Ironically, this policy would presume that one of the solutions to our economic woes is precisely the same thing that helped cause the crisis in the first place. Nevertheless, the mortgage backed securities market does need bolstering, and this plan would target that without increasing the Fed's balance sheet or forcing private banks to take losses by forgiving home loans, as some commentators and administration officials have suggested.
At present, Corporate America is sitting on nearly $2 trillion of capital, and the solution to economic instability is not to give them more capital to hoard, but rather, to induce lending of the capital already in the system. This may require a reboot of the secondary mortgage market, but it is important to keep in mind that when the market feared declining demand in the 2000s, it was never shy about creating new financial products that manufacture the necessary demand.
Obviously, this had disastrous implications and must be done on a much smaller scale with much greater oversight this time around. But if we wish to see liquidity in the system, the answer is not more QE -- it is incentives to lend. Investors should watch closely as the Fed begins to hint at just such a plan in Bernanke's Jackson Hole Symposium speech, and then keep an eye on a rapid response by the secondary mortgage markets.