Textbooks teach that when government budgets go into deficit, or if existing deficits increase, then interest rates rise. But there are exceptions. In recessions, for instance, government deficits usually go up because tax collections slide and payments to unemployed workers swell. But private sector demand for credit slumps, especially to finance business investment, which is disproportionately held back when the economy contracts. The fall in private credit demands is normally substantial enough to outweigh the impact of rising government deficits.
Whats more, the central bank usually decides to pursue an easier monetary policy by expanding the money supply faster. In the process, official short-term interest rates are lowered. With liquidity cheaper and private loan demand weaker, banks and other financial institutions buy securities rather than making more loans. In technical parlance, they move out the yield curve, thereby transmitting the impact of monetary accommodation to longer-maturity bonds. Lower bond yields induce some investors to shift into the stock market, even though price-earnings ratios calculated from the lousy profits performance that always accompanies an economic slowdown appear too high. If everything works out, the positive wealth effect caused by higher stock market valuations and elevated bond prices offsets the negative income effect from lower short-term interest rates, reversing the downturn in business investment and stimulating new hiring.
Where this rather conventional story breaks down is when an economic slowdown results from more profound imbalances in the economy. That was the case, for example, in Japan throughout the past decade or more. Similar obstacles to economic revival have been encountered in numerous emerging markets in recent years. The common denominator is almost always a set of problems in the banking system that prevents the standard sequence of positive reinforcement from taking place.
The Federal Reserve justifies its latest reduction in the Federal funds rate in terms of taking out an insurance policy. It is a preemptive strike against the small, but non-trivial, danger of deflation and against the debilitating effects of anticipated declines in the average level of prices on spending and thus on economic growth. Like a preemptive strike that has been made in a totally different context, however, there may be another rationale. The danger may have little or nothing to do with imminent deflation, but rather with very real, and quite apparent, financial problems in the US. What are some of the manifestations?
First, as business fixed investment has contracted, demand for credit by US corporations has fallen persistently since the cyclical peak in January 2001. Over the past 2 ½ years business loans from commercial banks operating in the US have dropped by nearly $175 billion, a fall of more than 15%. Over the same time period, issuance of non-financial commercial paper, an alternative source of short-term funding for large corporations, has plunged even more. It fell by almost two-thirds, from a peak of $360 billion to just $140 billion.
This is not an entirely bad development. Short-term borrowings have been more than replaced by a total of $520 billion of net new bond issues by non-financial corporations. These issues are for medium and long-term maturities, so they lengthen the maturity structure of corporate liability positions and therefore reduce exposure to funding risks later on.
However, this benefit comes at a cost. It raises annual interest payments on average about 4 percentage points above what they would otherwise have been had businesses kept the same level of bank loans and commercial paper. That amounts to more than $15 billion per annum in higher interest expenses or close to 5% of profits of non-financial corporations. And the benefits go disproportionately to more established, and more highly-rated corporations, rather than to smaller, newer, and riskier ventures with far less access to the corporate bond market. But these are the companies that create the bulk of the jobs in the US economy. Not coincidentally, the job situation in the US has not yet begun to improve.
Second, commercial banks have accentuated the process by continuing to tighten credit standards. Put simply, the Fed eased, but the banks didnt. The latest survey of bank lending practices was conducted by the Federal Reserve in April and the results were released last month. To be sure, far fewer banks are tightening standards than at the depth of the recession, when a net of 60% were doing so. But even with the gradual improvement both in corporate profitability and in company balance sheets, a net of 10% of banks were still tightening standards this spring.
The recent experience closely replicates the pattern following the 1990-91 recession but is actually somewhat more restrictive than in that episode. The tightening of credit standards reported in 1990 was virtually identical to the 2001 response. By 1992, when the US economy was entering a moderate recovery, however, credit conditions had stabilized the percentage tightening standards exactly equaled the proportion easing standards. By 1993, two years after the recession trough, which is comparable to the present situation, a net of 20% reported an easing of credit standards. And an even greater proportion of banks, over 50%, were narrowing spreads of loan rates over the cost of funds to large and medium-sized companies. By comparison, today a net of 15% of banks are still widening lending margins to companies of all sizes.
In conclusion, the extraordinary easing of US monetary policy has not succeeded in easing conditions in the short-term credit markets as quickly and as powerfully as in the past. Until that happens the Federal Reserve will retain a bias toward further ease.