The Bear’s Lair: How Trump can escape from Yellen’s trap

After the Federal Open Market Committee raised the Federal Funds rate by 0.25% last week it became clear that Janet Yellen and her predecessor Ben Bernanke have laid a trap for President-elect Donald Trump. Each time the FOMC raises rates, increasing the rates the Fed pays on $2.1 trillion of bank deposits with it, it lessens the incentive for banks to do any business lending at all. There is a way out of this trap, but it involves moving in a counter-intuitive direction.

The trap for Trump consists of those $2.1 trillion of deposits with the Fed, created as a part of Bernanke’s “quantitative easing” schemes. As is surely becoming obvious, the “stimulus” provided by those schemes was non-existent; indeed, why should they have stimulated? Essentially $2.1 trillion of government bonds held by the banking system was replaced by $2.1 trillion of “excess reserves” deposits at the Fed – equally inert, and equally clogging up the banks’ balance sheets, although equally given a zero multiplier by the regulators in their absurd Basel-3 capital ratio calculations.

This pointless balance sheet round-trip never stimulated lending, economic activity or anything else. If Bernanke had actually dropped $100 bills from a helicopter, as he promised in 2002, he would have stimulated economic activity on Main Street, from eager shoppers picking up the free money and spending it. But instead, his helicopter was metaphorical only, and hung only over Wall Street. It enriched Wall Street a bit but stimulated no meaningful economic activity elsewhere.

Now the downside of Bernanke’s scheme is becoming clear. Most U.S. banks get a great deal of funding from retail deposits at zero cost, although of course they incur massive branch network and personnel costs to obtain that funding (this is not true for Goldman Sachs and Morgan Stanley, and is only partly true for Citi, Bank of America and J.P. Morgan.) When interest rates are low, deposits with the Fed are not especially attractive assets, even though they are given a zero weighting in capital calculations, because they offer only a modest margin above the banks’ cost of retail funding, not enough to pay for the branches.

To raise short term interest rates, in the old days the Federal Reserve would adjust its purchases and sales in the Federal Funds market, to ensure that the Federal Funds interest rate met their targets. Banks needing short-term money would borrow in the Federal Funds market; those with an excess of short-term money would lend in it.

However today all the banks have a huge excess of short-term money, because of the QE deposits with the Fed. Hence the Federal Funds market is meaningless. The only way the Fed can raise interest rates is by increasing the rate it pays on deposits, to the top of its desired Federal Funds range. When that is done the modest Federal Funds market trades slightly below the deposit rate, because it is unattractive to lend Federal Funds, but always attractive for banks to borrow them and lend to the Fed (the margin may be small, but with no cost, no risk and no capital requirement, it’s picking pennies up off the street.)

Thus, each time the Fed raises rates, it becomes more attractive for a bank to take its retail deposits and re-deposit them with the Fed. Infinite leverage, an increasing margin, and no tiresome lending officers to feed or loan risks to take. If rates were to rise to 4%, it would become attractive for a bank with retail funding simply to place all its money with the Fed and do no lending at all – it could then repay all its capital above $1, under the absurd Basel-3

You can see the effect of this in the Fed’s bank lending statistics. In the last year, the Fed has lowered its borrowings from the banks by $360 billion (because it is borrowing that money from the Treasury Department, presumably in some legal dodge to avoid the debt ceiling coming into effect.) Banks’ commercial and industrial lending, which had been flat for several years, has increased by about $600 billion in the same period. In other words, by reducing the amount of QE deposits it takes from the banks, the Fed has finally managed to stimulate some economic activity.

Equally, if the Fed repays the Treasury once the debt ceiling is sorted out, and increases both its deposits from the banks and interest rates, we can expect the volume of bank loans to go into steep decline as rates rise and ordinary lending becomes relatively less attractive. Economic activity always tends to decline when rates are raised, but this would push it off a cliff. President Trump, welcome to the giant recession Bernanke and Yellen have gifted you!

The solution is to sell all the Treasury bonds held by the Fed as quickly as possible, repaying the banks their $2.1 trillion, and forcing the banks to get off their backsides and lend to business (and preferably not just to useless speculative real estate.) Once that is done, the banks would have to find other uses for their cheap funding; these might include Treasury bonds or loans, but at least the Fed would no longer be solving their assets problem automatically and allowing them to wallow in idleness.

Yellen and other Fed-lovers will of course tell you that you can’t dump $2.1 trillion of Treasuries into the bond market without wrecking bond prices. You would cause a massive decline in bond prices, a spike in long-term interest rates, and again, a deep recession. If interest rates are on their current trajectory of gradual upward moves and the Federal budget deficit is running above $500 billion, that is certainly correct. Bond dealers will not willingly buy something that appears to lead to inevitable large losses down the road – bang would go their 2017 bonuses!

The solution is to reverse course on interest rates, while selling the bond portfolio as quickly as possible, perhaps at the rate of $175 billion per month, getting rid of the whole $2.1 trillion within a year. At the same time as she does this, Yellen should drop the Federal Funds (and deposit) rate unexpectedly to 0.25%-0.5%, reversing last week’s rise. If dealers think interest rates are falling, they will be happy to snap up the Fed’s holding of Treasury bonds, even at the rate of $175 billion per month. European and Japanese banks will join in too, since they can keep their balance sheets in order by selling euro-denominated bonds to the ECB and Japan Government Bonds to the Bank of Japan under those institutions’ gigantic QE programs.

The result of this combination of policies will be a surge in bank lending, and an upsurge in inflation, as the U.S. economy rises towards full capacity. To control the inflation, the Fed will have to raise rates again, once it has got rid of its indigestible $2.1 trillion of Treasuries. The banks will then have no excess reserves, and will be forced to continue lending even as rates rise. In this scenario, long-term rates will not have fallen much as the Treasuries are sold off, even though short-term rates will be lower. Long-term rates will undoubtedly rise again once inflation takes hold (which is why the $2.1 trillion fire sale needs to be done quickly.)

The effect of these policies within a year will be a modest surge in inflation, which can be addressed through higher interest rates, and a surge in business lending (so Trump had better hold off on his infrastructure investment, which will just make the T-bond rate rise worse.) Of course, once the dust clears, the big Wall Street houses will all have massive losses on their holdings of long-term Treasury bonds.

This policy route will reduce the profitability of the large commercial banks and cause large losses to brokers as interest rates rise with inflation. Conversely, with bank lending increasing rapidly, it will result in a surge in profits to Main Street, much more so than infrastructure investment, which tends to end up with the big construction companies. It will thus reverse the effect of the last eight years, thereby reducing inequality and enriching the heartland states, which is both fair and what Trump promised.

In the long run, interest rates need to return to normal levels of 2-3% above inflation, to ensure proper capital allocation in the U.S. economy. But, given the $2.1 trillion of Fed deposits in the banks, just raising them to those levels as Yellen is currently doing (albeit agonizingly slowly) runs the risk of shutting down bank lending and the U.S. economy altogether. Getting the junk off the banks’ balance sheets and out of the Fed, reversing QE, is thus the first priority. This strategy of lowering interest rates and fire-selling the Fed’s Treasuries portfolio is the only way to do this. Wall Street will squeal, but Main Street will purr. It’s about time!

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)