The Fed left interest rates unchanged at its last meeting on June 18/19, 2019. Recent Fedspeak points to a rate reduction this time around in recognition of falling economic indicators and damage from the Trump Trade War.
The start of a global trend in downwardly moving interest rates looks to be in progress as they have to move inversely to the ever-growing stock of private debt as has been the case in Japan since the early 1990s.
The Australians (EWA) and New Zealanders (ENZL) are leading the charge at the moment with both countries having lowered their equivalent of the federal funds rate. Both these countries have private debt stocks of over 200% of GDP. (A
This article provides an impact assessment of the FOMC July 30/31 2019 meeting and a possible reduction in the Federal Funds Rate to 2.25% from 2.5%
The chart below shows the current FFR situation.
A movement of the FFR has four broad impacts:
- Bank lending costs on required reserves.
- The interest burden on private debt.
- The Interest on newly issued Treasury deposits.
- Interest paid on excess reserves, also known as the support rate.
These four impacts will are looked at in turn.
The table below shows the impact of rates on bank reserves advanced by the Fed, via the discount window, when a bank makes a loan.
(Source: Author calculations based on Trading Economics GDP measure)
The interbank rate is shown in the chart below and shows that at present commercial banks can get their funds in the interbank market at a lower rate than the FFR. The Fed has lost control of the FFR target rate because it is not allowed by law to issue bonds to make a reserve drain or add in the payment system. The debt ceiling rule is causing this anomaly. When the Fed is not able to maintain the FFR with bond sales and buys, the rate falls to zero or to the support rate if there is one. The Interest on Reserves [IOR] and Interest on Excess Reserves [IOER] is the support rate and is set at 2.35%. That is why the interbank rate has fallen below the FFR of 2.5% and settled at 2.35% and is covered in this article in more detail.
Every 0.25% rate movement changes the cost of loan funds by $10 billion. The private banks then pass on this rate change to the customer if they can.
The next aspect is the interest burden on private debt.
The following table shows the impact of the FFR on the stock of private debt in absolute terms and as a percentage of GDP.
The chart shows that with each 0.25% FFR change, $101 billion, or 0.54% of GDP, is transferred from the household and business sector to the finance sector in a macro intersectoral income transfer or vice versa.
At present, just over 5% of GDP goes to banks as interest on loans. Debt drag on the real economy.
Debt Drag: Akin to fiscal drag, the rate at which income earned in the production-and-consumption sector is diverted ("leaked") to pay to creditors.
(Hudson, Michael. J IS FOR JUNK ECONOMICS: A Guide To Reality In An Age Of Deception. ISLET/Verlag. Kindle Edition.)
A lowering of the FFR will give businesses and households in the real economy a big break and cause a flow of $101B to go back to the real economy and out of the banking sector.
Treasury deposits are the next major area of impact from a change in the FFR.
The following table shows the generalized impact of the rate rise on the stock of Treasuries.
The table above shows that with each 0.25% rate rise, some $55 billion of new money enters the private sector from the government sector. The positive side of the equation is that more dollars in the economy grow the economy.
An FFR decrease means that the economy receives $55B less each year by way of interest payments from the Federal Government to bondholders. Overall this is a net loss of income to the economy given that the Federal Government is a net payer of interest.
The fourth and last impact of a change in the FFR is the mutual adjustment of interest on excess reserves and interest on reserves.
At the last Fed meeting, the Fed left the headline FFR rate alone however a little known fact is that one thing they did do was to lower the IOER as shown in the chart below and discussed in this article.
Each time the FFR rises or falls, the IOER set to just underneath it. Most likely a decrease in FFR will lead to a fall in the support rate to 2%, and this will remove approximately a further $4.82 billion of money from the economy and bring the total paid per annum to $27.52 billion. The stock of excess reserves has fallen, and so has the interest rate.
The stock of excess reserves is shown in the chart below. A few months ago, it was over $1.5B.
This loss of income decreases the bank's capital base, which, in turn, means it must reduce its lending to remain within the limits of its capital ratio. Overall, therefore, this has negative ramifications on the creation of private sector credit, which has flatlined lately, as illustrated in the chart below. The treasury drought is adding to this problem because treasuries are required as tier 1 assets for stress tests and lending collateral and holding mandates and banks cannot get any at the moment due to the debt ceiling curtailing growth in treasury issuance. A strange rally in both bonds (TLT) and gold (UGLD) has developed as if there were a recession on the way, the former because treasuries are in short supply and the latter because gold is also a tier 1 asset and a treasury alternative.
Loans to the private sector in the United States has been as good as flat since January 2019. It is no coincidence that the flat growth trajectory mirrors the same growth trajectory as treasury bonds shown in the chart below.
Treasuries are tier 1 capital for commercial banks from which lending is collateralized. The Fed manages the FFR using reserve adds and drains via bond sales and redemptions; the stock of treasuries is by definition, the net money supply. If there is no growth in the stock of treasuries, there can be no growth in lending either.
There are winners and losers from changes in the FFR and IOER, and these can be assessed in terms of key actors in the credit markets.
Banks: On the one hand, banks pay less for their borrowed reserves from the Fed when they make a loan. This rise is good news for those that hold a lot of fixed-rate loans, as their margin is eased. On the other hand, those banks that have a lot of Adjusting Rate Mortgage (ARM) loans will not enjoy an automatic rate rise when the trigger rate is hit.
At present with the yield curve contracting around the FFR/IOER and short term rates being higher than longer-term rates, banks are not keen to lend long if this means earning no interest income or even worse making a loss.
Banks slowly devour a larger and larger share of GDP with each rate rise for no additional effort and no actual production of a good or service. A lower rate reverses this process.
Bank stocks can be expected to fall due to the reduced income from:
- Decreased loan interest from households and businesses on the existing loan book of over 197% of GDP. Even with lower rates, it is unlikely that the loan book will grow given how high the stock of debt already is.
- Interest on treasuries bought in exchange for excess reserves by the Federal Reserve goes down.
- Interest paid on excess reserves by the Federal Reserve bank goes down. Bank stock can be expected to fall (WDRW).
Borrowers: They suffer when rates rise and benefit when they fall. Borrowers in the household and business sector get slowly squeezed with each rate rise. More and more income is devoted to debt service, and the appetite for more debt reduced. Aggregate demand falls, and unemployment and recession follow. Rate decreases reverse this unhappy process and breathe more life into Main Street.
Macroeconomy: Gains income overall when rates rise and lose it when rates go lower due mainly to the size of the stock of treasuries. The following table shows the impact on the macro money supply at an FFR of 2.25%
(Source: Author's calculations based on FRED statistics and Trading Economics dot com statistics)
Contrast this with the present situation at 2.5% shown in the following chart.
(Source: Author's calculations based on FRED statistics and Trading Economics dot com statistics)
The net change to the money supply is minus -$49B (plus the drop in private credit creation and more still if the IOR is also adjusted down which it would have to be) and deflationary overall and shrinks the economy. One can expect a decline in GDP and also the inflation rate but that Main Street will counterintuitively do better because the debt drag from the banking sector by way of the interest burden is less.
What the above shows is that management of the economy via monetary policy is not sufficient, and the outcomes are uncertain and best summarized in the following quote:
Monetary policy is weak and its impact is at best uncertain-it might even be mistaking the brake pedal for the gas pedal. The central bank is the government's bank so can never be independent. Its main independence is limited to setting the overnight rate target, and it is probably a mistake to let it do even that. Permanent ZIRP (zero interest rate policy) is probably a better policy since it reduces the compounding of debt and the tendency for the rentier class to take over more of the economy. I credit Keynes, Minsky, Hudson, Mosler, Eric Tymoigne, and Scott Fullwiler for much of the work on this.
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.