Mone­tary pol­icy is still in terra incog­nita

Business Day - - OPINION - BRIAN KAN­TOR Kan­tor is chief econ­o­mist and strate­gist at In­vestec Wealth & In­vest­ment. He writes in his per­sonal ca­pac­ity.

The suc­cess of quan­ti­ta­tive eas­ing in pro­mot­ing a global eco­nomic re­cov­ery calls for its re­ver­sal: the re­sump­tion of more nor­mal mone­tary af­fairs.

The scale of quan­ti­ta­tive eas­ing — the creation of cash by cen­tral banks since 2008 — has been ex­tra­or­di­nary. Why this in­jec­tion of liq­uid­ity has not led to more spend­ing, much more in­fla­tion and far greater ex­pan­sion of the bank­ing sys­tems and in-bank de­posits than has oc­curred has been the big sur­prise.

Pro­vid­ing an ex­pla­na­tion for these highly muted re­ac­tions can ex­plain why the re­ver­sal of quan­ti­ta­tive eas­ing may also be less event­ful than might or­di­nar­ily be pre­dicted.

The total as­sets of the ma­jor cen­tral banks in the US, Europe and Ja­pan have grown from just above $3-tril­lion in 2007 to more than $13-tril­lion now and are still ris­ing. The Fed balance sheet grew from less than $1-tril­lion in 2008 to over $4-tril­lion by 2014.

The key fact to recog­nise is that al­most all of the tril­lions cre­ated by the Fed and other cen­tral banks buy­ing the bonds and other se­cu­ri­ties that so bulked up their balance sheets came back in the form of ex­tra bank de­posits.

Com­mer­cial mem­ber banks be­fore 2008 held min­i­mal cash re­serves in ex­cess of what reg­u­la­tions said they were re­quired to hold. They ex­ploded there­after. These ex­cess re­serves in the US peaked at $2.5-tril­lion in 2014 and re­main above $2-tril­lion worth of po­ten­tial lend­ing power.

The banks hold­ing cash rather than mak­ing loans or buy­ing as­sets has not only led to less spend­ing than might have been pre­dicted, it has also led to a much slower growth in bank de­posits.

It has shrunk the ra­tio of total US bank de­posits to the cash base of the sys­tem. This money mul­ti­plier has de­clined from nine times in 2008 to the cur­rent 3.5 times. There­fore, the size of the bank­ing sys­tem rel­a­tive to the GDP has de­clined and made the US econ­omy less de­pen­dent on bank credit. As at Septem­ber 27, the US com­mer­cial banks’ cash as­sets were equal to an ex­tra­or­di­nary 20% of their de­posit li­a­bil­i­ties.

Ex­tra bank lend­ing re­quires that banks at­tract ex­tra cash and ex­tra cap­i­tal. Banks were un­der­cap­i­talised be­fore 2007 and have had to add to their cap­i­tal-to-loan ra­tios. This has re­strained bank lend­ing, as has the re­luc­tance of po­ten­tial clients to bor­row more.

Hold­ing ex­tra cash rather than mak­ing ad­di­tional loans was an un­der­stand­able choice.

The ex­tra cash held by US banks also earns in­ter­est, a fur­ther in­cen­tive to hoard­ing rather than lend­ing cash. Low in­fla­tion — more so the fall­ing prices that char­ac­terise de­fla­tion — can make hold­ing de­posits with the Fed a good in­vest­ment de­ci­sion. Fed min­utes re­leased ear­lier in the week re­veal a con­cern that very low in­fla­tion may be “more than tran­si­tory”.

Com­ing re­duc­tions in the sup­ply of cash to the bank­ing sys­tem are very likely to be off­set by re­duc­tions in the ex­cess cash re­serves banks hold. Given the vol­ume of ex­cess cash re­serves held by banks, the dan­ger is still of too much rather than too lit­tle bank lend­ing to come. Were ex­cess cash re­serves to be ex­changed on a larger scale for bank loans, the Fed would have to ac­cel­er­ate its bond sales and raise rates at a faster pace. This would all be a sign of faster growth and wel­come for it. But there is a pos­si­bil­ity of a slip twixt cen­tral bank cup and lip if mar­kets mis­in­ter­pret the sig­nals com­ing from cen­tral banks, so adding volatil­ity and risks to mar­kets be­fore or as a new nor­mal is es­tab­lished.

Past per­for­mance will not be a guide to what will be an­other unique event in mone­tary his­tory — the re­ver­sal of quan­ti­ta­tive eas­ing.

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