Your Economy (No Politics)

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The upcoming expansion of US bank credit

Since the FOMC meeting, there has been a noticeable silence over the
Fed’s monetary policy following QE2. But there is some evidence that the
funding of government debt at low interest rates will shift to the repo
market, rather than a new round of quantitative easing.

The silence on this subject may be partly explained by the monetary
focus shifting to Europe. However, it is likely that the Fed has no
intention of introducing QE3, given that the expansion of narrow money
so far has led only to a degree of price inflation, without much benefit
to asset prices. And with the ECB still reluctant to print euros, QE3
would probably collapse the dollar/euro rate and propel gold
considerably higher, putting unwelcome strains on the financial system.
The Fed also finds itself having dramatically expanded the monetary base
for little economic benefit: against all its expectations, the economy
is sliding into recession again. Perhaps it is a case of all the people
being no longer fooled all of the time with respect to what QE actually
is. No, another approach is called for.

To the Keynesian mind the obvious alternative must be to expand bank
credit, particularly when there is an accumulation of non-borrowed
reserves sitting on the Fed’s balance sheet. The NBRs represent the
excess capital owned by the commercial banks, which have not been drawn
down for use as the capital base for the expansion of bank credit. They
currently stand at about $1.76 trillion while in normal circumstances
NBRs would be no more than a few tens of billions. High levels of NBRs
reflect the reluctance of banks to lend and bankable borrowers to
borrow: they are symptomatic of an economy that refuses to expand.

It is against this background that Ben Bernanke announced at the recent
post-FOMC meeting press conference that interest rates would be held at
current levels (close to zero) for the next two years. This could be the
basis for shifting the funding of government debt from printing raw
money to expanding bank credit. The public do not understand the
inflationary implications of expanding bank credit as easily as they do
that of printing money: switching to bank credit as a funding route for
government debt allows the Fed to fool all of us a while longer.

The logical way to do this is by developing the repo market, where the
buyer of government securities conducts a reverse repurchase agreement,
or a reverse repo. In a reverse repo an investor buys securities with an
agreement to sell them back to the seller at a fixed price at a future
date. For the seller of the securities, the deal is defined as a simple
repurchase agreement and is the mirror-image of the reverse repo. If the
cost of financing a reverse repo is profitable then the transaction can
be highly geared to give a substantial return on the underlying capital.
By encouraging this market for short-term government debt, the Fed can
exercise tight control over short-maturity government bond yields with
benefits extending to medium maturities, irrespective of the quantity
issued. The key to it is to get the banks to lend to the institutions on
the Fed’s Reverse Repo Counterparty List, and the key to that is
reducing the interest rate paid on non-borrowed reserves to slightly
below the targeted government bond yield rate.

The development of the repo market is the way to getting the NBRs put to
constructive government use. Given that short-term US government paper
is seen as the lowest investment risk and the highest quality
collateral, gearing up a reverse repo fifty or even a hundred times is a
no-brainer. Theoretically, that $1.76 trillion of NBRs could fund nine
times that amount of government debt, or more than doubling it to $30
trillion. The point is that the successful development of the repo
market in this way is an obvious and more powerful solution than
extending quantitative easing.

We know from FOMC minutes last year that the Fed have been assessing the
repo market, so it is a definite possibility. All that is required is
interest rate certainty, and that is what the Fed gave the market in its
announcement that it would peg rates at close to zero for the next two
years. The probability that the repo market will be developed in this
way has been increased by the inclusion on the 27th July of both Fanny
Mae and Freddy Mac on the Fed’s Reverse Repo Counterparty List. We
should be interested in this development, because it allows these
government-owned entities to gear up their fast-accumulating cash for
certain returns, and using government entities allows the Fed to
exercise further controls on the development of the repo market.

The apparent disadvantage is that reliance on the repo market will
shorten the overall debt maturity profile. But successful funding at the
short end of the yield curve will have the effect of keeping yields down
for longer maturities, and the Fed can also use derivatives to extend
its control to the longer end. Correctly managed, the Fed will believe
that it can keep the cost of government borrowing low and at the same
time manage the overall debt maturity profile.

We cannot be certain the Fed will use the repo market in this way, but
the problems with a new round of quantitative easing, the studies of the
repo market admitted in FOMC minutes, and the recent entry of Fannie Mae
and Freddie Mac to the Reverse Repo Counterparty List are strong
evidence they will. Furthermore, the establishment Keynesians and
monetarists will be unconcerned by inflationary consequences. To them,
the greater danger is still a 1930’s style deflationary depression, the
result of not enough government economic stimuli. Unlocking the NBRs and
gearing them up through the repo market gives them all the room for
manoeuvre they could wish for.

And if the Fed unlocks bank credit in this way, other central banks will
want to follow. This will not be so simple, since most banks in other
jurisdictions operate under Basle rules, which require them to maintain
a minimum level of risk-adjusted capital, instead of keeping reserves at
the central bank. Basle rules are being tightened, forcing most banks to
increase core capital as a percentage of loans, so there is less capital
available to back a dramatic expansion of repo markets for government
debt. Other central banks will have to use more imagination to expand
bank credit to finance government deficits.

In the short run, this may not matter too much. All currencies are on a
de facto dollar standard, so they will benefit from the dollar’s
extended low interest rates. Furthermore the expansion of bank credit as
a means of government funding in the US will reduce demands on the
global savings pool, easing the imbalance between government deficits
and funding availability.

So we have a workable monetary solution for all the world’s ills. There
are market benefits, too. Extended low interest rates should help place
a floor under asset prices, and the resolution of the immediate
uncertainties over US sovereign debt and less pressure for government
spending cuts will be seen as a confidence restorative. But expanding
bank credit to finance increasing government spending merely allows that
spending is no solution to the underlying causes of the real economic
difficulties.

Importantly, it guarantees yet more price inflation down the road: bank
credit expansion always has in the past, and it always will in the
future. Above all, it guarantees the next leg upwards in the precious
metals bull market.

Alasdair Macleod

17 August 2011

http://www.financeandeconomics.org/Articles%20archive/2011.08.17%20Bank%20Credit%20Repo.htm