Fed Funds Mantra Does Not Explain Growing Economy
The news is full of economists wringing their hands over what the Fed is going to do with the Fed funds rate, whether they have tightened too much or too little, and just what level of the “real fed funds rate” would be neutral. Meanwhile the economy keeps growing. What gives?
Monetary policy is a lot more than the Fed funds rate. What matters is whether the network of bank and non-bank lenders to businesses that make up the country’s credit markets are functioning or not. As the chart below shows, business loans are growing like crazy.
That’s important because credit markets don’t work like the textbooks and macro models would have you believe. In the textbooks, investors compare the interest rate with projected returns on projects. Raising rates causes them to trim marginal projects, investment spending falls and output contracts.
The real world is not like that. In 30 years of investing and owning companies, I have never seen an investment project accepted or turned down because Fed funds rates were 1% higher or lower. But I have seen plenty of projects cancelled and businesses shrunk because the credit markets imploded. It is the availability of loans, not the posted interest rate, that matters.
Monetary policy has its principal impacts on the economy not by moving the economy from one equilibrium point to the next, like in the textbooks, but by causing sudden, discontinuous changes, or “blackouts”, in credit availability.
The credit market is a communications network, no different from an electricity grid. Normally, credit markets function well. But, from time to time, a policy disturbance causes the network to “black out.” During these times, the credit market is far away from equilibrium and recorded prices (interest rates) are not a good metric for incremental borrowing costs.
Example: the period November, 2000 until May, 2004, during which business loans contracted from $1104 billion to $870 billion. During that period, Fed funds rates were pushed lower and lower, but total costs increased to borrowers, as evidenced by the land office business being done by mezzanine lenders during the period. This blackout was the principal reason the economy underperformed foreacsts during much of that period, which many referred to as the jobless recovery. Small businesses, which make up more than half the economy and nearly three quarters of hiring, have few alternatives to banks for working capital. When the credit market blacks out, they lay off their workers and output shrinks.
The credit blackout ended in May, 2004. Since then businesss loans have increased by $148 billion to $1018 billion (8/17). This gusher of credit has driven borrowing costs sharply lower for the average business borrower as banks, mutual funds, and hedge funds competed for business, even though Fed funds rates increased the entire time. That’s why growth and profits keep surprising economists. this is particularly true for bank-loan dependent small companies. This is why small- and mid-cap stocks have outperformed their big brothers and will continue to do so.
Network theory tells us that networks characterized by super-connectors–a small number of actors that are connected to many others–are especially prone to failures. The fed and Treasury, sitting atop the credit system, are both superconnectors of the first order. The result is on-again, off-again, monetary policy. We would bhave a more stable economy with a distributed processing system that pushed policy making out into the network, rather than controlling it from the center, for the same reason our flexible labor market works better than the centrally controlled labor markets in Europe.
The great econonists of old knew this. That’s why Wicksell, Keynes, and Irving Fisher wrote about credit collapses. It’s worth reading them again.
JR
The market for bank reserves has an impact on the supply of bank credit (C&I loans) as well as the cost (interest rates). When the Fed writes a check to buy T-bills, banks deposit those checks and the Fed adds the amount to their reserves. With more reserves, they can expand their portfolio of loans or securities. When the Fed raises the fed funds target that tells the open market desk not to add reserves so readily.
Raising short rates in a world of low inflation also flattens the yield curve. Since banks make money by lending over longer periods at a higher rate than they pay for short-term deposits, a flatter yield curve may lead to more stringent lending practices.
The link is to the article I was referring to in my previous post.
A hedgefund manager in an interview in Marketwatch on 9/1 was saying that it won’t be higher interest rates that burst the housing bubble but when lenders stop lending. He expects this to happen soon based on the inverse yield curve. After which he expects a Japanese style deflationary cycle.
I would normally discount this as just another doom and gloomer except that he made a ton of money betting on higher oil prices and a rise in the dollar this year.
I wonder even if the housing bubble bursts and mortgage lending drys up, can business sector lending stay healthy?
The same thing happened in Thailand after 1997 to +- 2002? ! But, there was a tremendous amount of coruption in the bank loan sections. People/businesses were borrowing the money but using it for other things, ???!
Marc Fabor, in his book “Tomorrows Gold”, wrote about his interest in reading the “old economists”.
One subject, “deflation” (across the board deflation), I would like to know which of the “old economist” write about this subject.
I look forward to reading your follow up article on this article.
Hi John,
Very interesting comments. Definitely agree!
The collapse in capital spending, early this decade, due to the dot com bust, would contribute to the decline in credit aggregates. And, when the FED lowered rates to record levels, no one was encouraged to borrow because of that aftermath. However, as things settled down, and the stock market rallied significantly, companies started looking to expand again, to capitalize on the newest wave of economic expansion.
Overall, the FED definitely does have an impact…but credit drives the economy.
Excellent post TY
Tony
Thanks Tony.
JR
Very interesting post — do you have more specific thoughts on what to read?
“The great econonists of old knew this. That’s why Wicksell, Keynes, and Irving Fisher wrote about credit collapses. It’s worth reading them again.”
Jim
Hi Jim,
I’ll write more in a post about this later today. All 3 lived through the banking panics and credit collapses that were part of the landscape every 20 years from after the Civil War to the Great Depression. They were the reason the price level in 1939 was the same as it was 100 and 200 years earlier. Best one to start with is Fisher’s Purchasing Power of Money (1896 or thereabouts). More to come.
JR
Can you just elaborate on the how this network blackout occured.. as in the factors that existed, the policy etc the led to this blackout.. how can we predict such blackouts in the future ?
RS
Great questions. I will post a piece a little later today with a reference/link to an op-ed I wrote on the subject in november, 1981, as well as links to the network theory guys who have been working on the subject.
JR