Does the Fed Lead Banks on Interest Rates, or Do Banks Lead the Fed?
It's not talked about enough, but in an economy of individuals (meaning, the only kind of economy) recessions are healthy. As individuals we regularly develop bad habits, and it's during recessions that we break them. Cris Carter was a good NFL receiver who scored a lot of touchdowns, but it was only after Buddy Ryan waived him from the Philadelphia Eagles that he was forced to confront his difficulties with drugs and alcohol. Carter's personal recession happily forced him to break his talent-sapping habits on the way to a Hall of Fame NFL career.
Looked at in the bigger picture, economies can't expand without failure. Absent the latter, the release of underutilized capital (human and physical) from lousy companies into better hands would rarely take place. Precious resources would be stuck. Recessions are the drivers of rebounds because it's during recessions that subpar and awful businesses are relieved of the resources they're underutilizing. Silicon Valley isn't the richest region in the world because all of its businesses succeed; rather its wealth is directly related to the fact that most every one of its startups eventually goes belly up. Silicon Valley has failed its way to massive wealth.
All of the above ably exposes why so much of what's said about the Federal Reserve is incorrect. It's said that the Fed's quantitative easing (QE) programs have artificially propped up the stock market, but the very notion is contradictory. Failure is once again the driver of market rallies - and economic booms - simply because it's the market corrections and economic recessions that force precious capital to its highest uses. Forget that eleven QE doses from the BOJ never authored a market boom in Japan, forget that for $4 trillion (the expansion of the Fed's balance sheet that allegedly found its way into stocks) to enter any market $4 million must exit at the same time, the greater flaw in the popular theory that says the Fed authored a stock-market rally is that it ignores why economies (and stocks) move upward in the first place. It's the recessions and corrections that drive the booms and rallies.
To provide yet another example revealing the absurdity behind the belief that the Fed created the U.S. stock market rally, it's worth remembering that stocks corrected - substantially - in China over a year ago alongside size government efforts there to prop up Chinese shares. Of course they did. It's the corrections that once again make the rallies possible for them starving the bad in favor of the good. When governments presume to prop up stocks or the economy they by definition weaken both. The Fed is not unique here. It can't engineer rising asset prices by giving buoyancy to that which would sink without it. Even if it could, this would be to the detriment of U.S. equity markets for the reasons previously explained. The idea that QE caused a market upturn defies basic common sense.
Much the same, the popular notion that the Fed is behind historically low rates of interest paid on bank deposits and savings should similarly raise eyebrows. About this, it's said that the central bank's low Fed funds rate target (the rate at which member banks lend to each other overnight) has robbed savers of reasonable interest on their bank savings. But does the Fed lead the bank channel, or do banks lead the Fed? It's an important question.
Figure the Fed can target any kind of overnight lending rate that it wants, but banks don't have to follow it. Just because the Fed desires a lower cost of bank credit doesn't mean that financial institutions must comply. If they can safely lend out the savings entrusted to them at high rates of interest then they can also pay savers high rates of interest on their deposits. The Fed funds rate is a target rate as opposed to a command.
More realistically, banks are paying very little for deposits simply because they can't earn a high return on those same deposits. There are lots of theoretical explanations for this, but none of have much to do with the Fed.
One factor in low deposit rates is the bank bailouts from 2008. While insolvent banks should have been allowed to go under so that they could be acquired by better financial institutions, many were instead saved from an early death with government help. It says here that the latter weakened the banking system (imagine how unhealthy Silicon Valley would be if Webvan, eToys and theglobe.com had been bailed out back in 2000-2001), but whatever one's opinion it can't be denied that banks with questionable assets were kept alive. Since they were, is it any surprise that having faced death, they're now being extra careful? If so, it's only logical that they would pay less for deposits that they're unwilling to expose to risk.
On the other hand, imagine if they'd been acquired on the cheap back in '08. Their new owners would necessarily be able to more aggressively lend simply because they'd now own an asset (and underlying assets) that had appreciated substantially from the depths of '08. Since they could more aggressively pursue profits from deposits they could also pay more for them.
And let's not forget the regulations that emerged in the aftermath of 2008. Having saved some of the banks, politicians and regulators have essentially set about strangling them all with rules on how they can earn returns. Proprietary trading desks have famously been jettisoned by regulatory decree, subprime mortgage lending that can generate higher returns exited. In my book Who Needs the Fed? I write about how a southern California bank that considered getting into the business of financing accounts receivable faced a three-year regulatory review.
What about the fines banks have faced? Wells Fargo just lost its CEO and agreed to a fine of $185 million because a microscopic percentage of its bank tellers, eager to achieve higher monthly bonuses, faked the opening of new customer accounts. These actions didn't cost Wells customers any money, but they did cost the bank money. Still, for having fired the errant employees who embezzled Wells Fargo, Wells was forced to agree to a major fine. As the Wall Street Journal's Greg Ip recently explained it, "Investors must now discount the possibility that any bank could be a scandal away from indictment and a huge fine." Absolutely.
So with banks no longer a good investment, it's no surprise that only one new banking company (Bird In Hand) has incorporated since 2010. If banks can't be innovative or dynamic, why enter the space in the first place? Banks would love to pay higher rates of interest to depositors simply because the latter would signal dynamic growth within banking. But since banks have been reduced to straight-jacketed utilities, it's no surprise that the rates of interest they offer are low.
Applied to the Fed, assuming a funds rate of 1, 2, or 3 percent target, odds are banks wouldn't increase what they pay for deposits. How could they? Once again, if they can't do what it takes to earn substantive returns on savings, they can't realistically pay a lot for same.
Looked at in a broad sense, what's happening with the bank channel through which the Fed presumes to influence the economy is yet another reminder of how overrated the Fed's power over the economy is in the first place. As Ip put it, "Shrinking, unprofitable banks [have] hobble [d] that transmission channel." With banks shrinking, so is the Fed's power. This is yet more evidence exposing as laughable the notion that a Fed expressing its economic influence through shrinking banks somehow authored a major, multi-year, stock market rally.
Of course the hobbled nature of banks also calls into question the idea that the Fed's actions have harmed savers. Not really. The federal bailouts, fines and regulations have harmed U.S. savers. It's a reminder that when it comes to short-term rates, weakened banks are leading an increasingly irrelevant Fed far more than the Fed is leading banks.
