Hedgeye Guest Contributor | Thornton: Another Unintended Consequence of QE

Editor's Note: Below is a Hedgeye Guest Contributor research note written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This column does not necessarily reflect the opinion of Hedgeye.

Hedgeye Guest Contributor | Thornton: Another Unintended Consequence of QE - Fed cartoon 10.24.2014

Last weekend’s Wall Street Journal (WSJ, July 23-24) reported that large banks are “bolstering their reserves…to prepare for an uptick in loan losses” (p. B1). The WSJ went on to note that this was part of a strategy to increase loan volume and that some banks are lowering credit score requirements and making riskier loans to increase loan volume.

This report is not surprising. The Federal Open Market Committee’s (FOMC’s) QE program incentivized lending by forcing banks to hold a massive amount of excess reserves and paying them a low interest rate to hold them. While this consequence of QE appears to be unintended, there is no reason that it should have been. 

The figure below shows that nearly all of the excess reserves created by the FOMC’s massive purchase of mortgage-backed securities, agency debt, and long-term Treasuries are held by large banks. I noted in a previous CSE Perspective, here, that banks have lent aggressively during the last 7.5 years. Specifically, they made loans equal to over 70% of the loans made during the tech and real-estate booms from January 1994 to November 2007. Moreover, they made these loans despite the fact that economic growth during this period was only about 40% of that of the previous period.

Hedgeye Guest Contributor | Thornton: Another Unintended Consequence of QE - thornton1 7 27

Given the FACT that each dollar reduction in excess reserves supports about $9.2 dollars in total checkable deposits, the massive lending resulted in more than a doubling of the M1 money measure—a larger increase than occurred during the previous 30-years! Despite the massive increase in lending and the nearly $44 billion increase in required reserves that it produced, banks—mostly large banks—still hold $2.3 trillion in excess reserves.

Why didn’t the lending during the 1994-2007 period produce an even larger increase in the M1 money supply? Answer: Because that lending was “financed” by banks issuing large-denomination certificates of deposit (CDs), not by excess reserves. Excess reserves averaged under $2 billion during that period. Indeed, the market for large CDs has essentially vanished because large banks do not need to borrow in this market to make loans.

Banks have been aggressive in making loans because during the past 7.5 years the Fed has paid an interest rate that is significantly below the risk-adjusted rate on bank loans. The Fed paid just a quarter of a percent, 0.25%, on excess reserves until December 17, 2015, when it increased the rate to 0.50%. Banks should have made all loans that had a risk-adjusted interest rate higher than the rate the Fed paid on excess reserves. I argued that this FACT incentivized banks to make riskier loans then they would have made in the absence of QE.

Furthermore, banks could not possibly make the $23 trillion in loans and investments required to reduce excess reserves to their pre-September 2008 level. The WSJ’s article confirms my conclusion. Scarier still is the WSJ’s report that large banks are reducing their lending standards still further in an attempt to increase their loan volume. While the riskier lending that QE produced appears to have been unintended, there is no reason that it should have been. I noted on several occasions that the effect of QE on the money supply would be very large because banks would have an incentive to make loans whenever the risk-adjusted rate on loans exceeded the rate the Fed paid on excess reserves, 2009, 2012.

That banks have made such loans and are poised to make even riskier loans is just another harmful consequence of QE. For other negative consequences of QE, see Monetary Policy Insanity. Particularly troubling is the FOMC’s unwillingness to acknowledge the negative effect of QE and its reluctance to reduce the size of its balance sheet to return excess reserves to pre-September 2008 levels.

The FOMC has failed to do so in spite of the Facts that:

  1. As I have shown elsewhere, Bernanke’s claim (Bernanke, 2010; Bernanke, 2013) — that the largest effect of QE on long-term rates occurred because QE reduced term premiums on long-term Treasuries — is theoretically flawed;
  2. To reduce long-term rates QE requires financial markets be segmented along the term structure, which is in opposition to a wide body of evidence that financial markets are efficient;
  3. QE was motivated by the misguided belief that the recession was intensifying and wouldn’t end soon; the recession ended just 3 months later, and;
  4. There is no compelling evidence that QE significantly reduced long-term rates, see Requiem for a complete explanation of these points