A really excellent article out of USA Today talks about inflation and how inflation rates are too low due to loan rate growths. This concept comes from Milton Freidman's line of thinking that inflation is derived from the money creation process of fractional banking; a bank loans out its excess reserves creating more money. However, the Fed's policies have stymied the very act they are trying to create. Despite this, higher interest rates via the Fed removing extraordinary, and excess, policy procedures may very keep the low growth of inflation.
What is the loan growth rate
Loan growth rates are benign, at best. The top chart here shows the M4 numbers, or all commercial and industrial loans, done by banks to customers. This is where Milton Freidman claimed inflation was derived. Simply, if banks have a given amount of funds deposited they can lend out 90% of that. This is the basis behind fractional reserve banking. This is how money is created. And, the demand of that is what brings about inflation.
Above, you can see the money supply rate of growth over the past nearly 30 years. I also added the inflation rate in the bottom chart (Red Line). This shows how inflation moved higher with higher growth rates in loans, from money.
The Future of Interest Rates
The process of the Fed removing policy accommodation means that the Federal Reserve is going to stop rolling bonds over into new investments. As bonds come due, the Fed will not be reinvesting these funds. This means that liquidity is essentially being removed from the banking system and that banks are going to be restricted in their future lending. The Federal Reserve was adding paper to banks
November was the very first full month of the end of the roll-over. Apparently, no one told the stock market that as the Dow ripped through all-time highs. Typically, the equity market moves lower in a higher-inflation environment.
The Fed is winding down their purchases of US securities as well as MBS bonds. They are expected to let go of about $300 billion the first year and then another $500 billion the second year. When the Fed was purchasing these securities over the past they were pushing prices of treasuries and bonds higher, inversely pushing interest rates lower.
When the Fed's buying program ended, some assumed that interest rates would be elastic and that there would be a bounce back upwards in interest rates. That did not happen simply because unlike when a large player moves the market, the Fed does something different: They create money out of nothing.
Now, however, I question if the reverse is going to happen, albeit at a far slower pace. If the Federal Reserve were to purchase a bond, perhaps from the US government, then during the process, with the stroke of a key, the Fed created something of value out of nothing. They gave those 'invented' funds to the US government or a mortgage holder, and those funds were used as needed. The borrowing entities then paid interest. Now, the bond is due to mature. The initial funds need to be returned to the Fed where, with the stroke of a key, the Fed will dispose of something of value.
This would have the opposite effect on bond prices as it did in the beginning. The biggest reason is that the Federal Reserve was always purchasing approximately 10% of the market at any one time. Now, the government needs to find a new customer. Most likely, this is going to have the effect of driving the price of the instrument lower to entice an investor. However, I expect the effects to be modest.
The reason why is that most bond auctions are oversubscribed already. There is enough interest in government debt to keep the price contained for some time; I do not see interest rates heading higher in a very hast manner.
Inflation in the future
Because of the Fed's activities, interest rates are going to rise over time, but, very slightly. At the same time, however, loan growth rates are not likely to move upwards quickly. With the Federal Reserve effectively removing money out of the system, albeit via bond purchases to the government or to mortgage holders, some other investor is going to have to step back into the marketplace to take the place of the Fed.
That movement will mean funds that potentially could have been deposited into a bank are now going to be invested outside of the banking system. This will dwindle reserves at banks. Again, I believe this will be modest. However, that modesty will keep loan growth rates lower for some time.
At the same time, a bank's spread on what they borrow their funds, from short-term securities, and lend out long term, are not going to change drastically over time. There will not be a large impetus for banks to push lending standards so that more funds may be lent out, and, ultimately, expand the M4 levels that would create inflation.
I do not see elevated inflation rates any time soon. I see a lot more of the same, growth in the economy via GDP numbers, but levels that are below what anyone would call brisk. Without large amounts of lending, at elevated rates, income growths are likely to remain muted, as well. Inflation numbers are likely to remain lower for longer, and the Fed will be slow to raise interest rates as the economy works through the large buildup in the balance sheet they created.
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.