The Federal Reserve’s apparent willingness to fund US national debt inexhaustibly gives cause for concern about future inflation. A record-breaking growth in the money supply due to the Fed’s quantitative easing bond purchases threatens price stability. An even greater risk – one that is at the heart of economic opportunity in democratic capitalism – is the impact of Fed decisions on private bank lending.
Banking institutions have traditionally provided the pipeline that brings loanable capital to businesses and households. However, commercial banks are increasingly choosing to reduce the proportion of credit they account for total assets while expanding their holdings of government bonds and government-backed mortgages.
According to the Fed, the 25 largest US banks currently hold 45.7% of their assets in loans and leases Data released Friday, down 54.1% around that time last year. Meanwhile, their holdings in Treasury and Agency securities rose 33.5% year over year. This reflects tighter credit standards and lower credit demand. But there is also a subtle but persistent change in the way banks work.
Banks have pulled out of risky loans to get in more direct contact with the Fed. They avoided the type of lending that led to stricter regulatory standards after 2008, while willingly taking into account the Fed’s explicit satisfaction with an “adequate reserves” regime. Small business lending was low in the post-crisis years, with the largest falls in small business lending being with large banks, according to 2018 report on behalf of the Small Business Administration.
The switch is understandable. The cost of regulatory compliance is a major disadvantage for banks, and selling government-backed securities to the Fed and building reserves can turn out to be a profitable business model.
However, the impact on productive economic growth should give Fed officials a break, who may be wondering why banks decided to keep reserve balances on their Federal Reserve custodian accounts sky-high, currently $ 3.15 trillion, although the Fed eliminated all reserves requirements in March 2020. If commercial banks leverage those reserves that are available for loan to fund private borrowers, it could enable robust growth.
However, whether banks will increase personal lending is a key factor in determining the inflation outlook. Money growth is a function of both money supply and speed. As banks lend and add to the money supply, the frequency with which a dollar is spent buying goods and services increases as more transactions take place between individuals. The rate of the Fed’s broadest monetary measure, M2, has plummeted from 1.806 in the fourth quarter of 2008, before the Fed launched its first round of quantitative easing, to 1.134 in the fourth quarter of 2020.
Will inflation now rise due to the exceptional monetary stimulus to ease the coronavirus? “I can tell you we have the means to deal with this risk if it happens,” Treasury Secretary Janet Yellen told CNN last month, sounding like a central banker. “The main risk is that we will leave workers and communities scarred by the pandemic and the economic toll it has brought with it.”
Ms. Yellen, who chaired the Fed from 2014 to 2018, knows the tools. She was a Fed official throughout the post-crisis period when the central bank added massive treasury purchases to its balance sheet. “We could raise rates in 15 minutes if we have to,” her predecessor Ben Bernanke told CBS’s “60 Minutes” in December 2010. Reduce inflation at the right time. “
Jerome Powell, Ms. Yellen’s successor, does not appear to be affected by the risk of inflation either. Speaking to Congress last month, he stressed the need to improve labor market conditions, noting that “the high unemployment was particularly severe for low-wage workers, as well as for African American, Hispanic and other minority groups.”
But the Fed has maneuvered itself into an untenable political position by introducing an inflation tolerance – which harms low-income workers the most – which runs counter to its price stability mandate. If the goal is to restore pre-pandemic conditions to high employment, boost wage growth and improve productivity – which has benefited minorities in particular – the Fed should refrain from measures that discourage banks from lending to small job-creating businesses. Productive business growth, fueled by tax cuts and deregulation under the Trump administration, requires access to credit.
However, banks must now take into account Mr Powell’s statement that the Fed will continue to increase its holdings of Treasury bills and agency mortgage-backed securities “at least” at its current rate ($ 1.44 trillion per year). Coupled with the Fed’s mechanism to immediately increase interest paid to banks on reserves, approved as an emergency measure in 2008, the managed interest rate is now the Fed’s main leverage. The dilemma for banks is whether to continue their risk-free interaction with the Fed or take the chance for private borrowers.
America’s future as a free market economy depends on overcoming a fundamental dilemma: Any entrepreneurial endeavor that is potentially productive is inherently risky. It is in the nature of capitalism. Still, access to finance capital is vital to improving a person’s prospects for economic prosperity – an essential aspect of making the American Dream come true.
The Fed must avoid turning banks into state-owned utilities by providing incentives to accumulate reserve balances while enforcing compliance parameters that hinder risk-taking. The aim is to stimulate, not stultify, productive economic activity – the kind that increases production and warrants higher wages. Workers do best when banks find it profitable to invest in private companies to become reliable partners for the people who want to develop products and provide services.
The decisions of the central bank are intended to support, not replace, the real economy. The Fed’s approach to killing with kindness runs the risk of permanently damaging banking relationships by restricting access to credit. No wonder the movement to democratize finance is increasingly being pursued by non-banks.
Ms. Shelton, an economist, is the author of “Money Meltdown”.
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