Monetary policy is still in terra incognita

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.