Loans and Deposits - Why the Economy Isn't Growing

Here's a simple graph that goes a long way to explaining why the recovery has been so modest despite Mr. Bernanke's (and presumably Ms. Yellen's) Grand Experiment with interest rates:

The red line shows deposits with all commercial banks and the blue line shows loans and leases with all commercial banks in billions of dollars.  Notice that until the Great Recession, the growth level in both deposits and loans and leases rose in tandem.  It is quite apparent that the tight relationship between deposits and loans broke down in the early part of 2009.  

Here is a graph showing the loan-to-deposit ratio and how it has dropped to levels not seen since the early 1980s:

Right now, banks are only lending 76 percent of their deposits, a level last seen in June 1983.  Also note that the drop in lending-to-deposits is showing no sign of abating.

Let's flip loans and deposits around so that we end up with the ratio of deposits-to-loans as shown here:

Right now, banks are taking in $1.31 in deposits for every $1 that they loan to consumers and businesses.  This is up quite markedly from $0.98 in deposits for every dollar that they loaned in May 2008.

Here is a graph showing the excess of commercial bank deposits over the amount banks have loaned:

Between 1973 and 2009, the excess of deposits over loans never rose above $433 billion and was generally below $400 billion.  In contrast, in October 2012, deposits exceeded loans by $2.307 trillion, a new record amount. As you can see from the graph, the growth in deposits over loans is showing no signs of slowing down, a situation that looks very unhealthy.

So, what is it that banks are doing with the $2.3 trillion in deposits that they are not lending to consumers?  Here is a look at the same loans and leases curve (in blue) with the reserve balances held by the Federal Reserve Banks (in red):

More than 6000 depository institutions maintain balances at the Federal Reserve Banks in reserve accounts.  In October 2013, banks had just over $2.311 trillion on deposit with the Federal Reserve.  This is money that is not loaned out and, in fact, after 2008, the Federal Reserve paid interest on these reserves.  By paying interest on reserves, the Fed could both increase the level of reserves and maintain control of the federal funds rate by permitting the Fed to expand its balance sheet to provide the necessary liquidity to support financial stability.

Just before the Great Recession, the required reserves (in red) averaged about $43 billion as shown here:

As you can see, that level changed once the Fed started paying interest on banks' reserves which have grown to a level in excess of $2.3 trillion, a 5350 percent increase in five years!  As you can see on the black line which shows excess reserves, banks are using the Fed as their own bank largely because, since 2008, the interest paid on both required and excess reserves has stood at 0.25 percent, a completely risk free return particularly when compared to loaning to consumers and businesses.  Prior to 2008, the Fed was not obligated to pay any interest on bank reserves, providing the commercial banks with absolutely no motivation to deposit excess monies with America's central bankers as shown here (in purple):

From the data presented here, it certainly appears that the Federal Reserve's policies are working against economic growth.  When banks stop lending, the economy stops growing and the Fed appears to have made it way too easy for the commercial banks to invest in lower risk activities.

Looking Ahead at the Fed

A recent Economic Letter taken from a speech by John C. Williams, President and CEO of the Federal Reserve Bank of San Francisco, looks at the latest economic recovery.

Mr. Williams begins by noting that, while aspects of the economy have recovered since the depths of the Great Recession, it has not rebounded as quickly as central bankers and the rest of us had hoped with the pace of growth being modest, particularly when compared to past recoveries.

Here is a graphic from his presentation showing the changes in real (inflation corrected) GDP growth per person over the five year period since the beginning of the latest recession shown in solid red for the United States and the black line which shows black for the 150 year average of 17 advanced international economies):

Note that 95 percent of the time, real per person GDP growth falls within the grey shaded area.

The solid red line shows that the American real per capita GDP fell by over 5 percent by the second year of the latest recession, a substantial drop when compared to historical economic retrenchments. 

Now, take a look at the dashed red line.  This line shows the forecast of real per capita GDP growth from an economic model that looks at past recessions and recoveries.  The model suggested that the huge buildup in private sector credit prior to the recession resulted in a deeper than normal recession and that the economy should have been stagnant well into 2012.  If you compare the dashed red line (the projection) to the red line (the reality), you can see that the economy grew faster than it should have given the extent of the credit bubble.  Unfortunately, many Americans would suggest that the fact that the latest economic recovery was among the weakest in 150 years does not speak well for the actions taken by the Fed.

According to Mr. Williams, the credit for this unexpected growth lies with his fellow central bankers at the Federal Reserve and the extraordinary measures that they took which pulled us out of the Great Recession at a faster pace than anticipated.  That said, he notes that all sectors of the economy are not firing on all cylinders, particularly in the public sector where government budgets are in a no-growth situation particularly at the state and local level where dropping revenues have resulted in cuts to both employment and spending as shown here:

Since the end of 2009, governments at all levels have cut more than 600,000 employees and government spending has fallen nearly 7.5 percent.

Mr. Williams goes on to outline the impact of the Fed's policies on the mortgage markets; after all, buying $85 billion worth of Treasuries and mortgage-related securities every month will have an impact on the mortgage market.  At the bottom of the recession, 30 year mortgages could be had with an interest rate of 5.5 percent.  Today, these same mortgages are about 1 percentage point lower.  A homeowner buying a home with a 20 percent downpayment and a $300,000 mortgage at 5.5 percent resulted in a monthly payment of $1360.  Under the current interest rate scenario, this drops to $1220, a saving of $1700 annually which "...could be saved or spent"  Alternatively, a homeowner willing to pay $1360 per month could buy a house worth more than $335,000, boosting demand for homes."  My guess is that the Fed would prefer that American consumers consume rather than save and, as shown here, that's just what's happening:

The savings rate has dropped from a high of 6.5 percent during the recession to its current level of 3.2 percent (off its post-recession low of 2.2 percent).  As well, household debt-to-GDP, while down from its 2009 highs, is beginning to grow again and hit 84.87 percent in the third quarter of 2012.

What does Mr. Williams see in his central banker crystal ball?  He suggests that inflation will gradually rise to the Fed's 2 percent target, hitting roughly 1.75 percent in 2015.  Unemployment will fall to 7.25 percent by the end of 2013 and drop to 6.75 percent by the end of 2014.  This is still above the Fed's target of 6.5 percent.  As a whole, inflation-corrected GDP growth will be 2.25 percent in 2013, rising to 3.25 percent in 2014.

With all of these projections in mind, when will the Fed end its experiment?  Mr. Williams' suggestion is that "it is still too early".  He notes that the Fed needs to ensure that the economy maintains its growth momentum in the face of the current fiscal contraction taking place as sequestration cuts work their magic.  He also suggests that the Fed needs to make certain that inflation doesn't come in below expectations, a scenario that could take place if the demand for goods drops due to consumer spending cutbacks resulting from uncertainty.

Mr. Williams states that a large majority of FOMC Committee members do not expect the first increase in the federal funds rate to take place until 2015 or later; as well, the median projected value of the federal funds rate at the end of 2015 is only 1 percent, hardly a massive increase above its current level of 0 to 0.25 percent.

Let's close with his summary:

"As I emphasized at the start, I am convinced that our extraordinary policies during the recession and recovery, including our current asset purchase program, have been hugely beneficial for the economy. The good news is that the economy is on the mend. The time will come when we will no longer need to keep adding monetary stimulus. When that time comes, I am confident that we can make this change without jeopardizing the recovery, while working toward our goals of maximum employment and price stability."

There's nothing like a central banker patting himself on the back and blowing his own horn.  Only time will tell whether he should be patting himself on the back and blowing his horn at the same time....or not.  In looking back at the first graphic, while things could have been worse, the recovery certainly was modest at best.