Why the Fed must let rates rise
This week all eyes are on the Federal Open Market Committee (FOMC) and Federal Reserve Chairman Ben Bernanke. The FOMC must decide whether to stop monetizing the federal debt issued by the Treasury, which is what the U.S. central bank calls “quantitative easing.”
Americans continue to believe — and hope — that the Fed can save us from our collective idiocy when it comes to debt, both public and private. While there are growing signs that the Fed’s zero interest rate policy, or “ZIRP,” is greatly damaging individuals and financial institutions alike, we also need to question whether the Fed can let rates rise without provoking another financial assets collapse.
In effect, the Fed and other global central banks are all caught in a “Catch-22″ situation, to borrow the phrase from the 1961 novel by Joseph Heller. The Fed’s aggressive easing of interest rates and purchases of trillions of dollars in Treasury debt and other assets has stabilized and even raised the price of financial assets, but in other respects the Fed’s policy of reflation has failed — especially compared with past interest rate cycles.
In a comment published by IRA this week, Chief Monetary Economist of Cumberland Advisors Bob Eisenbeis notes:
“From the 50s through 70s, the main channel for monetary policy was through housing: when interest rates exceeded the Reg Q ceilings that banks and thrifts could pay for funds, the supply of funding to housing was cut off. Then construction declined and the effects rippled through the rest of the economy. Most of the economic models have that structure and international isolation embedded within them. Yet this is not the world that policy makers are now dealing with … “
In an earlier comment in one of my pieces on Reuters.com, I looked at the fact that “the Fed faces continued asset price deflation at home even as the impact of its accommodative policies are already boosting global inflation.” My friend and mentor Alan Boyce, who ran the risk book at Countrywide, has been trying to educate people in Washington about the lack of “trickle down” money in terms of the Fed reliquifying the housing sector.
While the Fed’s QE and ZIRP have been a boon to the largest banks and investors on Wall Street, Main Street has been left in the cold. The continued decline in home prices in February as reported by Case-Shiller — now down eight months in a row — has been ignored to a great peril by the Obama administration. As I’ve noted previously in this blog, how does President Obama expect to win reelection if the U.S. housing sector and the banks that hold these assets are melting down come election day 2012?
Last summer, my firm earned condemnation from Wall Street for suggesting that U.S. banks were not out of the woods and that net interest margins were starting to fall. Dawn Kopecki at Bloomberg reports: “At JPMorgan, almost half of the New York-based bank’s earnings came from the release of reserves previously set aside to cover bad loans. Net revenue at the second-largest U.S. bank dropped 8.9 percent to $25.2 billion.”
The reason that revenue at many banks is falling is largely due to the Fed’s policy stance, but also reflects the still dismal economic situation on Main Street. Most banks are seeing the revenue from interest earnings fall as older assets run off and new assets with far lower yields are put in their place. But the lack of demand for credit from consumers and business is also a big factor behind the sharp drop in bank assets.
The chart below is of the gross loan yield for Bank of America vs. its large bank peers. It is taken from the IRA Bank Monitor using data from the FDIC and shows the gross yield on the loan book for Bank of America Corp’s subsidiary banks going back a decade. Notice that in the 2000 timeframe, just before Chairman Bernanke joined the Fed and his predecessor Alan Greenspan stepped on the monetary gas pedal, bank’s were earning yields on loans almost two times today’s levels. Notice, too, how competition in the 2005-2007 period drove bank loan yields down, but from 2007 the Fed’s QE and ZIRP temporarily boosted lending spreads.
Now, however, the benefits of Fed easing and FDIC debt guarantees are fading. Bank loan yields are starting to fall as lenders compete ever more aggressively for the few borrowers in the market who want credit and can actually qualify for a loan. The shrinking pool of earning assets and the lack of yield on these assets is perhaps the greatest danger to the banking system — and makes it next to impossible for Chairman Bernanke to put off raising interest rates much longer.
As we told clients of The IRA Advisory Service last week during the Q1 2011 earnings reports from the banks:
Our predominant impression from top universal banks is slack revenue to date and weak demand, and thus doubtful backlog going forward. In Q1 2011 US banks are reflecting the true situation facing their customers in the US economy. We were struck this past week by the fact that several bank executives basically said during calls and Q&A that the Fed needs to allow rates to rise so as to counter the effects of the accelerating run-off of earning assets and subsidized funding such as FDIC TLGP. Perhaps the appropriate policy formulation for the Fed is to force the cost of funds up while continuing to support overall volume of market liquidity via QE, reductions in bank reserves. End of QE without liquidity support is a very dangerous path for this fragile market in our view.