May 2018  Fed Meeting: Impact Assessment On Inflation, Markets, And Recession Risk

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Includes: DFNL, DPST, FAS, FINU, FNCF, FNCL, FTXO, FXO, IAT, IYF, IYG, JHMF, KBE, KBWB, KBWD, KBWP, KBWR, KCE, KRE, PFI, PSCF, QABA, RWW-OLD, UYG, VFH, XLF
by: Alan Longbon
Summary

The Fed left rates as they were at 1.75% at its last meeting.

Rate increases are inflationary and this risk has been abated for a further three months, only the rising oil price is a problem now.

Each rise in the Fed rate adds to the private debt servicing burden that shrinks the real economy in favor of Wall Street bankers.

This article provides a fundamental impact assessment of the decision by the FOMC to leave the Federal Funds Rate [FFR] 1.75% at its last meeting on 1-2 May 2018. Before the May 2018 meeting, I wrote an article on the FOMC meeting and the arguments for and against raising rates and a look at possible impacts.

For the better, the Fed decided to leave the rate at 1.75%, as the chart below shows.

What Happens when the Fed Changes Rates?

A movement of the Fed funds rate shown above has two broad impacts:

  1. Bank lending costs on borrowed reserves.
  2. Interest burden on private debt
  3. Interest on newly issued Treasury deposits.

These three impacts will be looked at in turn.

Bank Lending Costs

The table below shows the impact of the rate rise on banks reserves advanced by the Fed when a bank makes a loan.

(Source: Author calculations based on Trading Economics GDP measure)

When a bank creates a loan, it creates a deposit in the recipient's bank account and borrows funds from the Fed to cover the loan amount, if it cannot source them more cheaply in the interbank market. Loans create deposits and generate reserves at the Fed. The Fed creates the reserves on demand as part of the federal payments system.

Every 0.25% rate movement changes the cost of loan funds by $7 billion. The private banks then pass on this rate change to the customer.

A Fed funds rate increase can be seen as a giant, economy-wide tax on borrowers and lenders. Each time the Fed raises the rate 0.25%, it moves $7 billion from the private sector to the government sector.

The Fed is the national government's bank and remits its profits to the national government in the same way that taxes are remitted from the private sector to the government. Because the national government is the issuer of the dollar, it has as many dollars as it wishes to create and does not need to get them from an outside source. The $7 billion income stream to the government from a Fed rate rise is simply deleted from existence in the same way as national taxes are. It is a net reduction in the money supply.

On balance, the latest decision leaves the $7 billion in the money supply. The impact on commercial banks and their customers depends on the size and compilation of the loans on issue and whether the inbuilt exploding rate trigger in the ARM loans is activated or not.

If the rate change causes banks to be more profitable, this profit can be added to their capital base and given that banks are capital constrained and not reserve constrained they can then issue more credit based on the larger capital base.

This process works in the other direction too. When a bank makes a loss, this comes off their capital base, and their lending capacity is reduced. In the GFC many banks had no capital base left at all and were closed down with catastrophic impacts on the rest of the economy.

Interest Burden on Private Debt

The following table shows the impact of the rate on the stock of private debt in absolute terms and as a percentage of GDP. The current Fed funds rate is highlighted in green.

The bulk of loans are for real estate mortgages. The rate for homes is about 4%. About half of the loans in America are fixed-interest, and half are adjusting rate mortgages (ARM), where the interest rate moves up with the Fed funds rate. In the latter case, the banks welcome a Fed funds rate rise, as it can be passed onto the customer, often with built-in 2% jumps past a certain threshold. These are also known as exploding rate loads. A 4% ARM loan can explode to 6% on a 0.25% Fed funds rate increase due to the terms of the loan if the trigger rate is hit.

The danger with rate rises is that eventually a level is hit whereby the loan holders cannot afford the servicing cost and default. The banks then make a loss which comes off their capital base and reduces their lending capacity.

If the losses are large enough a bank's capital base can be destroyed and then it has to close.

In an extreme case, this causes a run on the banks and a financial crisis like the GFC.

One can have too much of a good thing.

Treasury Deposits

Another impact of a rate change is on Treasuries. If there is a general rate rise, then the yield on Treasuries will also rise as new Treasuries are issued at the new higher rate, and existing ones trade on secondary markets for lower face values.

The following table shows the generalized impact of the rate rise on the stock of Treasuries in absolute terms and as a percentage of GDP. (Treasuries do not have to be issued at all, and that is covered in this article.)

(Source: Author calculations based on Trading Economics Government Debt measure)

The government credits the bank accounts of coupon recipients to pay interest on issued Treasuries. The number in the bank account of the recipient increases upon direction from the Treasury. At that point, new money ("State Money") enters the private sector and adds to the money supply.

With each 0.25% rate rise, some $53 billion of new money enters the private sector from the government sector. This is the positive side of the equation in that more dollars in the economy grow the economy.

This also runs in reverse when rates go down.

If all the Treasury deposits were at the new rate, then the government would add $369 billion to the economy each year. The actual figure is lower, as the chart below shows. This is because most of the deposits are earning a lower rate of return than the new ones will do.

This gives the banks more income. As part of the Fed's monetary operations, it is required to swap bank reserves for Treasury deposits until it hits its target rate of 1.75%. The Fed swaps bank reserves for Treasuries at the new higher rate, and the income stream from the Treasuries flows to the banks and is higher than interest on reserves of 0.25%.

A larger interest rate may lift the demand for Treasury deposits. While domestically this is only a portfolio shift, it might improve the current account balance when foreigners buy more Treasuries.

On Balance, What does this All Mean?

There are winners and losers from a Fed rate rise.

Banks: On the one hand, banks must pay more for their borrowed reserves from the Fed when they make a loan. This is bad news for those that hold a lot of fixed-rate loans, as their margin gets squeezed. On the other hand, those banks that hold a lot of ARM loans are anticipating or enjoying the triggering of exploding rates that are much more than the actual Fed funds rate rise. Banks will now be able to swap their excess reserves for Treasuries at the new higher rate and enjoy more income. On balance, the banks come out ahead thanks to the rate rise. This means they can make more profit and expand their capital base and lend even more.

Given the current decision is to hold there is no change for banks.

Borrowers: Suffer when rates rise and benefit when they fall.

Given the current decision is to hold there is no change for borrowers.

The macroeconomy: The impact on the macroeconomy is dependent on the relative size of the two debt stocks.

Taken to extremes, interest rates can rise so high that so much private sector income is allocated to debt service that the aggregate demand for real goods and services is weakened to recessionary levels.

The chart below shows the stock of private debt and the stock of Treasuries.

(Source: Professor Steve Keen)

When the stock of private debt is larger than the stock of government debt, the impact of a rate rise is a larger removal of dollars from the economy.

The extra $7 billion interest on reserves paid to the Fed by the banks which the Fed then remits to the national government reduces the benefit of the $53 billion of extra interest the government pays back to the private sector in Treasury deposit interest. On balance, the private sector stock of savings has been increased by $46 billion with each Fed funds rate rise.

If private sector debt were less than the stock of Treasury deposits, the impact would have been larger.

If the Fed carries out its plan to increase the Fed funds rate four times this year, it will have set in place a mechanism that adds $184 billion, or 0.7% of GDP, to the economy each year through Treasury interest payments.

The overall impact of this has to be weighed against the impact of dollar creation by banks and also by fiscal policy and also the current account balance. This can be summarised in the sectoral balances after the work of British economist Professor Wynne Godley.

Recent, current and projected sector balances are shown in the table below:

Private Sector

[P]

External Sector

[X]

Government Sector

[G]

2016

0.6%

-2.6 %

3.2%

2017

1.08%

-2.42%

3.5%

2018 Congress budget

1.79%#

-2.5%#

4.29%#

(Source: Trading Economics, FRED and Author calculations based on the same)

* Estimate to be updated when the end-of-year numbers are known.

# Forecast based on existing flow rates

At present, the private sector balance is positive, but only weakly so at about 1-2%. This means that:

  1. Businesses and households are saving overall, and that net financial assets can grow in value.
  2. Overall. There is more currency added to the money supply than removed.
  3. Most of the newly minted dollars flow overseas to the external sector in return for the real benefit of goods and services.
  4. Recessions normally occur the private sector balance is zero or negative, and this has not happened yet.
  5. Recessions normally occur when the interest rate inverts, this means the FFR is more than the 10-year bond rate. This too has not happened yet and have been postponed by three months due to the latest Fed decision.

Summary, Conclusion, and Recommendation

A rate hold decision extends the economic expansion at a time of a general rate rise environment.

Rising rates boost the banking sector in the following ways:

  1. Banks receive more interest income when their reserves are swapped for Treasury deposits as part of the Fed's monetary rate setting operations.
  2. Banks that hold more ARM loans than fixed-rate loans will receive more interest income from borrowers than they pay out on borrowed Fed reserves.
  3. Banks that hold ARM loans where the exploding rate trigger has been activated will enjoy a larger than the rate rise boost to interest income on their loan book. Others will be nearer the trigger point.
  4. The economy generally benefits as more treasury interest income flows to bondholders and expands the money supply.
  5. Banks benefit from increased profits which add to their capital base and allow them to lend more.
  6. One can have too much of a good thing though, at some stage the overall interest servicing debt burden on private debt drains aggregate demand and puts the economy into recession and then everybody loses. By not raising rates this time around the Fed has put off by three months the start of the next recession.

In general, at a time of rising interest rates an investor can take advantage of the macro situation via a position in the following financial sector ETFs:

(XLF)

Financial Select Sector SPDR Fund

(VFH)

Vanguard Financials ETF

(KRE)

SPDR S&P Regional Banking ETF

(KBE)

SPDR S&P Bank ETF

(IYF)

iShares U.S. Financials ETF

(FAS)

Direxion Daily Financial Bull 3X Shares

(IYG)

iShares U.S. Financial Services ETF

(FXO)

First Trust Financials AlphaDEX Fund

(FTXO)

First Trust Nasdaq Bank ETF

(FNCL)

Fidelity MSCI Financials Index ETF

(KBWB)

PowerShares KBW Bank Portfolio

(UYG)

ProShares Ultra Financials

(IAT)

iShares U.S. Regional Banks ETF

(KBWD)

PowerShares KBW High Dividend Yield Financial Portfolio

(QABA)

First Trust NASDAQ ABA Community Bank Index

(PSCF)

PowerShares S&P SmallCap Financials Portfolio

(KBWR)

PowerShares KBW Regional Banking Portfolio ETF

(KCE)

SPDR S&P Capital Markets ETF

(KBWP)

PowerShares KBW Property & Casualty Insurance Portfolio

(DFNL)

Davis Select Financial ETF

(PFI)

PowerShares DWA Financial Momentum Portfolio

(JHMF)

John Hancock Multi-Factor Financials ETF

(RWW-OLD)

Oppenheimer Financials Sector Revenue ETF

(FINU)

ProShares UltraPro Financials

(DPST)

Direxion Daily Regional Banks Bull 3X Shares

(FNCF)

iShares Edge MSCI Multifactor Financials ETF

Personally, I prefer KRE as it is representative of domestic U.S. banks who enjoy the full benefit of the rate rise.

Disclosure: I am/we are long KRE, UDOW. 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.