The charts illustrate the unprecedented monetary policy we have had in this business cycle and its relationship to bank lending. The ZIRP (zero interest rate policy) and the QE (quantitative easing) were designed to replace the traditional role banks play in providing credit to the economy. The chart at the top, which begins in 1959, shows that Fed Funds (the short-term interest rate) had never been at zero before 2008 – a very unusual monetary policy for the Federal Reserve. The chart underneath measures the ratio of bank reserves relative to the money supply. Note the spike in the chart in 2008, from 5% to over 50%. Before that, the ratio had not exceeded 20%. Reserve requirements for loans remain approximately 10% ($100 in reserves for $1,000 in loans), while actual reserves today are about 65% ($650 in reserves for $1,000 in loans) and have recently been as high as 100% ($1,000 in reserves for $1,000 in loans). The money creation process, by which reserves are lent out 10 to 1 (10% reserves) by the banks, has not been functioning. Stress tests and other capital requirements have discouraged bank lending. As a result, extra reserves created by the Fed continue to sit at the banks.
This is unprecedented in the era of fractional reserve banking. Fractional reserve banking allows banks to lend out more than their reserves and it is what makes a bank a bank. We have been in an era of nearly “full reserve” banking. This is one reason peer-to-peer lending has grown in the post-2008 period. Anyone with extra cash can be a bank and make loans, particularly to those unable to qualify for the “available to the most credit worthy” bank loans.
The absence of available mortgage credit has pushed home ownership rates down to record lows and rents up to record highs. Low interest rates have created other distortions in the financial system. The need for income has driven up the prices for private and publicly traded real estate. Many other income producing investments have, like bonds, been driven up in price.
The ZIRP has not produced high inflation, as some had feared, because of the mirror image relationship of the two charts (limited money creation). As bank regulations start to ease under the new administration, the Fed will be challenged to adjust monetary policy rapidly enough to stay ahead of inflation. It will also be challenged to simultaneously manage the unwinding of the distortions in the financial system that their policy has created. For example, the “taper tantrum”, of a few years ago, gave us a taste for how rapid unwinding could shock bond liquidity and ETFs.
As responsible investment professionals, our challenge is to help our clients anticipate and act to alleviate adverse impacts on their investments from the great unwinding process.