A structural change in the plumbing of the banking system is dampening the impact of monetary policy and may even make rate hikes inflationary. Rates hikes now directly increase the asset returns of banks while leaving their funding costs unchanged – effectively encouraging credit creation. This is because banks have shifted their funding structure away from rate sensitive money market funding to rate insensitive retail deposit funding. The shift is due both to Basel III raising the regulatory costs of money market funding and also the superabundance of retail deposits from pandemic fiscal spending. On the depositor side, the public is also unlikely to see the increases in deposit rates that would arise from a competition for funding. This means the opportunity cost of holding cash will remain low well into the hiking cycle. In this post we review the transition to an asset return implementation regime, show how it changes the incentive structure of banks, and suggest that rate hikes may not be effective in slowing down economic activity.
Marginal Cost to Marginal Return
In practice, the implementation of monetary policy through banks has changed from adjusting the marginal cost of funding (federal funds rate) to adjusting the marginal return on assets (interest on reserves). This change results from banks moving away from the federal funds market, and money markets more broadly. The shift is an intended consequence of Basel III, which sought to make the financial system safer by discouraging the use of short-term funding. Data shows that major banks have steadily shifted their funding profile from over 30% in money markets Pre-GFC to around 10% today. (Note that the Federal Funds Rates is technically still the Fed’s policy rate, but it has ceased to be relevant for over a decade.)
In addition, banks today have much less need to borrow in money markets as pandemic spending has created a superabundance of retail deposits. The trillions in QE funded transfer payments have increased the retail deposit holdings of domestic banks by ~$5t. Retail deposits are the cheapest source of funding available to a bank because retail depositors are willing to receive 0% interest even when market rates are much higher. Bank lending decisions are shaped more by their opportunity cost (IOR), than their funding costs.
A shift to retail deposit funding means that asset returns increase with rate hikes, but funding costs do not. When banks were reliant on money market funding they would manage their business so that increases in funding costs would be off-set by increases in loan interest income. Bank earnings came from a spread between assets and liabilities that was unaffected by changes in interest rates. In 2006 even a 2% shift in interest rates would have little effect on JPM’s earnings. The business model today appears very different.
JPM’s latest quarterly report shows even a 1% shift in rates would increase earnings by $6b. Higher rates now directly increase bank earnings, and thus encourage credit creation. This may not necessarily come in the form of loans to businesses, as demand for loans may decline with higher rates. But credit creation could also be loans to the government (buying Treasuries) or home buyers (Agency MBS). A recent JPM earnings call notes that they could easily deploy $200b into Treasuries if rates rise. The new dynamic suggests rate hikes lead to a flatter yield curve, lower nominal rates, and potentially higher inflation through increased credit creation. (Recall, bank security purchases are paid for through the creation of money.)
Hikes Are For Banks
The superabundance of retail deposits suggests that Fed hikes will have a very limited passthrough to the public. Banks typically pass on Fed hikes to the public in the form of higher deposit rates as they compete for cheap deposit funding. Higher deposit rates could in turn dampen consumer spending by raising the opportunity cost of cash. The pass-through of rates hikes to depositors was very limited in the last hiking cycle, and will likely be non-existent this cycle as the supply of deposits has since increased by several trillion.
The RRP Facility is the one source of competition that could potentially lead to higher deposit rates. Fed hikes automatically increase the RRP offering rate, which increases money market fund net yields, which may entice some depositors to move into money market funds. Note that in the prior hiking cycle depositors did not begin shifting into money funds until Fed had hiked to 2.5%. The higher level of rate insensitive retail deposits this cycle suggest that even higher rates may be needed to offer meaningful competition.
The Borrowing Channel Remains
Rate hikes will still filter through to the borrowing costs of the real economy, but that may not matter when liquidity is already high. Larger companies are buying back their stock at record levels, suggesting that they have so much money they are returning it to shareholders. Smaller businesses just received over $1.1t in forgivable pandemic assistance. Households have a multi-trillion cash pile. Demand for loans may decline, but it’s not clear how binding a constraint the price of credit is on economic activity. If a decade of ZIRP shows anything, it is that economic activity is dependent on many more things than just the price of money.
The primary impact of Fed hikes will likely be through the financial channel. Every hike reduces the market value of fixed income investments, with the losses transmitted more broadly through the (often leveraged) portfolios of investors. The good news is that the “reverse wealth effect” channel has a reliable record of subduing inflation by tanking all commodity prices.