The tap still left open

Continuing fiscal laxity in the US means monetary policy must do more of the inflation fighting, increasing risks of financial accidents

Neelkanth Mishra | Last Updated : May 08 2023 | 10:16 PM IST

This appeared in the Business Standard on 9 May 2023 (link).

Volatility in stock prices of US banks has persisted, even as the concern about deposits has receded. Since policymakers have protected depositors in their interventions in failed banks, but equity holders have generally been wiped out, it is not surprising that shareholders of banks with large unrealised losses are worried.

The challenges, though, run deeper. While the surge in deposit outflows seen in March has abated, the steady fall that began a year ago is likely to continue. The quantity of money in the US (as measured by M2, or broad money) by early April was $1.2 trillion less than at the peak, down 6 per cent, and is likely even lower now. Bank deposits, which account for 83 per cent of the stock of M2, are down more than $1 trillion from the peak in April last year. Just in the last two weeks, well after the mid-March disruptions, bank deposits have declined $274 billion, a fall of more than 1.5 per cent.

Only a part of the fall in deposits so far is due to retail depositors switching to money market mutual funds (MMMFs), attracted by higher rates on offer. Most of it, instead, is due to the shrinking supply of US dollars, which is driven by quantitative tightening (QT) and slowing credit growth. Through QT, the central bank is gradually reducing the supply of money to control inflation. A stronger driver generally is slowing credit growth: Banks create money when they give a new loan, and conversely, if they do not roll over loans on maturity (either as they want to preserve liquidity or because the borrower wants to repay, say due to higher interest rates on loans), they drive a contraction in the quantity of money in circulation.

Continuing changes in savings behaviour, as visible in depositors shifting to MMMFs from low-yielding deposits, can hurt bank profitability, as banks try to slow outflows by increasing bank deposit rates. However, the shrinking supply of money should be a deeper concern for the system.

As banks respond to higher cost of funds, credit conditions tighten further: Loans carry higher interest rates and become harder to get, including for industrial and commercial borrowers. Banks are expanding their margins too: Well before deposit outflows accelerated in March, in the Federal Reserve’s January 2023 survey, the net response on increase in spread of loan rates over cost of funds was a high 40 per cent. In the past, when this ratio has been at this level or higher, a recession has followed in the US. While overall financing conditions are still loose in absolute terms, as seen in the still strong credit growth, they are the tightest since 2012 (ex-Covid), implying credit growth is likely to slow sharply going forward.

As important as the systemic changes are the spread of these changes within the US banking system. The well-flagged stress on small banks is likely to increase vulnerability where they dominate the flow of loans, like credit availability for smaller businesses (which account for 47 per cent of private employment and 43 per cent of GDP in the US), and commercial real-estate (which is anyway stressed by the changes in work habits post-Covid: Mobile phone activity in several major cities is still significantly below pre-Covid levels).

This is how monetary policy tightening is expected to work: The lending channel or the supply-side of credit tightens, and higher interest rates weaken borrowers’ balance sheets, reducing demand for credit. So, while the above trends imply speed bumps ahead, that is the intention. Further, banks in aggregate have a healthy capital position, and system-level profitability as measured by return-on-equity is the highest since 2007. We believe the main worry, therefore, is not a concern about systemic bank failures.

The risk is from vulnerabilities in the financial system exposed by a faster-than-expected growth slowdown, and rates staying higher for longer.

In most systems, “extend and pretend” is generally the first response to systemic problems, including by regulators. So, one can keep holding assets whose market-values have fallen, hoping that rates will soon fall and the losses do not need to be realised. Sustained high rates not only challenge this pretence, but also substantially raise rollover risk for weak borrowers. After all, firms (not just banks) fail mostly due to lack of liquidity; insolvency is rarely a sufficient condition for bankruptcy. Unless they are forced to refinance maturing loans at significantly higher rates, many “zombie” firms (companies whose operating profits cannot cover their interest costs) can continue operating.

While financial markets are challenging the “dot-plots” (interest rate projections by Federal Open Market Committee members), and pricing in cuts later this year, this would only occur if the economy were to slow sharply in the coming months. In the past, and even during the Volcker-era in the early 1980s, it took much longer than a few quarters of high rates for inflation to fall to the target range of 2 per cent. It is possible, if not likely, that the recent decline in treasury yields that is being interpreted as anticipation of rate cuts is just due to surging flows into MMMFs, which has increased the demand for treasuries.

Perhaps more importantly, while the profligacy of Covid years has ended, fiscal deficits in the US are still the highest in many decades if one excludes crisis periods (like 2009-2011 and 2020-2021), and still rising. This explains a large part of the resilience in end-demand and in the labour markets despite the increase in interest rates. According to the Congressional Budget Office, federal deficits as a share of GDP are set to increase to 6.1 per cent in the next two fiscal years, from 5.3 per cent this year, and further to nearly 7 per cent a decade later (though much of the increase after 2025 would come from the growing interest burden).

If fiscal policy continues to be loose, to control inflation monetary policy would need to be tighter than it would have been otherwise to compensate for this profligacy, implying money supply must shrink further and rates stay higher for longer.

Over and above the risks from a one-sided fight against inflation, this lack of fiscal and monetary policy coordination is likely to be a policy overhang for the rest of the world, particularly economies that are dependent on foreign capital flows, which in turn depend on the cost of dollar-denominated funds.