personal views of a former fed trader

Inflationary Hikes

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.)

Big US Banks no longer rely on money market funding. Source: UBPR

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.

Transfer payments increased retail deposits by ~$5 trillion

Hiking Earnings

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.

Higher rates increase funding costs but also interest income, so on net had a limited effect on earnings.

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.)

A shift to deposit funding meanings funding costs are 0%, so rate hikes increase earnings

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.

Rate hikes do not pass through to depositors

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.

2.5% was when depositors shifted into money funds

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.

37 Comments

  1. Felipe Schuback

    Hi Joseph, thanks for the great post. I do have some questions though:
    1) isn’t it risky for the banks to count on retail deposits as their funding source?
    2) what makes you conclude that there is a higher level of rate insensitive retail deposits this cycle?
    3) wouldn`t the retail deposits search for yield as soon as the Fed starts to hike?

    Thank you.

    • Frank

      Interesting question. I worked for a local European bank. When we looked at the figures our retail deposits were actually very stable. Many people like to have some savings which they can use when needed. The amount often tends to be much larger than needed. It looks as if people can take it away any day but in practice it simply stays on bank accounts forever.

    • Joseph Wang

      Retail deposit are considered the most stable because they are rate insensitive and don’t leave even during financial distress (FDIC insurance). This assumption is also written into the regulations. I show in my graph above that retail deposits have increased by several trillion from fiscal spending. Retail deposits historically don’t care about rates very much.

      • Anonymous

        Hi Joseph – thanks for the answer. Quick follow up though: what makes you think this significant amount of retail deposits will remain there? As you said, the reason they are there is mainly because of COVID transfers from government to the population. Once this amount is spent (household consumption takes place), shouldn’t this source of funding decrease significantly?

        • Joseph Wang

          So in our economy there is huge wealth inequality, so basically money funnels from the bottom to the top. I agree that over time it will funnel through, but it takes time. (also note that companies pay salaries, so it’s not all one way to the top).

  2. Wei Zhou

    Hi Joseph, i’ve heard of you by listening to one of the Bloomberg podcasts. Since then i’ve been reading your articles and book. I just want to say thank you so much for sharing your knowledge and thoughts which are so valuable and practical.

  3. Darcy Ungaro

    Hi Joseph – thanks for the great article, it’s pretty interesting.

  4. emre

    Hi Joseph

    Thought provoking, thanks.
    Could you please expand on the higher bank interest income -> higher inflation causation?

    Thanks

    • Francis

      All the more as the article says at the end that a “reverse wealth effect” tanks commodity prices! It is nice of J. Wang to share his knowledge, but I am sorry to say that I do not find this article convincing regarding the thesis “higher rates lead to higher inflation”.

    • Joseph Wang

      It increases the incentive for banks to create credit – so making more loans or buying securities. Often that also means lowering loan standards and accepting lower rates to attract more borrowers. More credit creation is usually inflationary.

      • Wei Zhou

        In my opinion higher inflation normally leads to higher rates though. In terms of credit creation, borrowing willingness of the private sector also matters so the key of the inflation debate really depends on which part of the rate curve initiating the higher rate.

  5. Thomas

    Really look forward to reading your articles.
    If I have it right you’re saying that deficit spending during the pandemic resulted in record retail bank deposits which could be the impetus for a secondary pulse of inflation since banks can borrow from that and higher rates incentivize them to make more loans which would result in more inflation.
    However, if we’re moving into a secular inflationary period, shouldn’t the long end of the curve steepen? Does the bond market have it wrong?

    • Harry

      What I read about is that some evidences currently from on the run bonds suggested that due to the past decades of ZIRP environment, investors now might be after those scarcely high coupon bonds, given the duration risk of lower coupon bonds posed by high inflation-high interest take relationships, which caused the dip in certain tenor on the long end of yield curve.

    • Joseph Wang

      Not all bond investors are sensitive to economic conditions. For example, if you are a bank and you are required to hold safe assets like Treasuries then you are inclined to buy bonds even if they are low yield. This is especially true when banks can now fund at 0% with retail deposits – BOA has already bought a few hundred billion. Other liability driven investors like pension funds may simply buy to balance their longer term liabilities. My own view is that inferring economic conditions from bond prices is like inferring TSLA future revenue from TSLA stock prices – not that helpful

      • Thomas

        I understand much of the demand for treasuries is not yield sensitive.
        So we shouldn’t be paying attention to the yield curve anymore as an indicator of credit conditions? I thought the Fed paid a lot of attention to stuff like 2s10s and corporate/treasury credit spreads.
        My personal view is that we’re in the tail end of the long term debt cycle so rates can’t really go up all that much any more. Technological deflation, debt deflation, demographic crunch all of this contributes to rates staying lower for longer. And the government has to carry much of the burden of credit creation from now on through deficit spending to keep credit conditions stable as you’ve mentioned.
        Is this a inflationary pulse a temporary one time pulse or do you think we will enter a period of secular inflation? Thanks in advance for replying.

  6. ST

    But if the banks to plow heaps of money into buying treasuries for example how would rates rising not end up significantly impact them?

  7. Pedro

    Quite an interesting article and refreshing perspective.
    Assuming that retail savings will not be widrawn or that there will be no increase in deposit rates (hard to believe), I would argue that central banks / regulators have tools at their disposal to regulate any excess credit if they wish to.

  8. YB

    Hi Joseph,

    Great post. Thank you. I plan on picking up your book as well.

    On your last point – “the good news is that the “reverse wealth effect” channel has a reliable record of subduing inflation by tanking all commodity prices.” Are you suggesting that higher rates will translate to higher rates on corporates which will cool demand for commodities? Do you think this would be offset by continued strong consumer demand given very low opportunity cost and continued fiscal stimulus?

    It appears we are in for low rates and high inflation for some time unless there is something that tips us into hyperinflation.

    Best,
    Yerzhan

    • Joseph Wang

      I just mean when the market can’t handle high rates and crashes it will also take down commodity prices a lot. Commodities tend to be bought on leverage, so they move a lot when the market pukes.

  9. D

    According to Fed data 65% of total household deposits/ belong to the top 10% of households.

    https://fred.stlouisfed.org/release/tables?eid=813668&rid=453

    Another fed chart specifically about the top 1% checkable deposits and currency show a nearly $800 billion jump since the beginning of the pandemic to Q2 2021. I wager most of that from cashing out a portion of stocks.
    https://fred.stlouisfed.org/series/WFRBLT01005

    If most checkable money is owned by a small portion of the population, how could there be high inflation if rates were to rise? If a stock market crash occurred, wouldn’t the top decile plow back there deposits into a heavily discounted stock market?

    • Thomas

      “If a stock market crash occurred, wouldn’t the top decile plow back there deposits into a heavily discounted stock market?”
      For every stock transaction there is a buy and seller, it doesn’t effect the amount of money in the system. Money does not go into stocks when someone buys a stock because there is a seller of that stock that receives the cash into his/her account. Cash on the sidelines is a misnomer.

      “If most checkable money is owned by a small portion of the population, how could there be high inflation if rates were to rise”
      This is a good rebuttal to Joseph’s theory. The rich have nearly all the deposits and thus don’t need to make more loans even though banks are willing to loan to them while the poor could use loans but do not have the collateral for the banks to issue those loans.

      • rsm

        Does leverage, collateral transformation, rehypothecation etc. provide ample credit creation to fund stock purchases? Can I borrow money to buy your stock, and keep the loan rolling over indefinitely? Is that new bank money creation?

        Why try to control inflation, anyway?

        《it is not clear what is gained by controlling the price level. If business cycles are caused by real factors rather than by things that are affected by the rate of inflation, then many of the reasons for controlling inflation vanish.》 – Fischer Black, “Noise”

        《The costs of putting inflation adjustments in contracts or of publicizing changes in the money stock or the price level seem low, so it is not plausible that these costs play a significant role in business cycles.》(Ibid.)

        Why aren’t COLAs and inflation swaps the obvious solution to inflation?

  10. TS

    I read your articles every time you put them out and love them! Thank you so much!

  11. grabodan@web.de

    Hi Joseph,
    thanks for your interesting article(s).
    I do struggle to follow the logic in this one. As you elaborate, higher rates mean higher bank income (on their reserves). Why would banks use those reserves to create loans, when the reserves just became more profitable? Wouldnt the opposite occur? Currently banks are desperate to lend money, especially in europe, because of low rates aka low income.
    So, rates are opportunity costs on loans. Higher rates mean the interest rates on loans will go up, which reduces borrowing and thus reduces inflation.
    Best
    Daniel

    • Joseph Wang

      It’s an interesting question – do low rates encourage credit creation of higher rates. I think it has more to do with the margins a bank receives. In the Eurozone you have deposits floored at 0% and yet the policy rate is negative, so margins are very low. I can’t imagine making loans makes sense – note also the Eurozone bank stocks remain below 2008.

      Nominal rates can go higher, but it doesn’t necessarily mean that low demand declines. For example, if we are in an inflationary environment nominal rates can rise but still be cheap if inflation rises faster. In that instance if your deposit rates are still at 0% then your margins are expanding and you are incentivized to create more credit (which would obviously be at rates higher than IOR).

  12. Gabriel Forest

    Can someone tell me (sources would be great too) where the Fed gets the interest to pay the banks on their reserves and excess reserves, and how it is paid? Is it paid in the form of cash (sent to the banks from the Feds cash reserves), and NOT paid into the reserve accounts? If so, this would seem to mean that SOME reserves could in fact escape into the real economy. And if the Fed significantly raised interest rates on reserves and/or excess reserves, this would be inflationary to the tune of billions of additional dollars injected into the real economy, especially if this cash incentivizes lending/new money creation.

    • Joseph Wang

      IOR is paid out of the Fed Treasury/Agency MBS interest income. So Fed has tons of interest payments flowing in from their QE portfolio, which they use to pay IOR on reserves. The interest is paid in reserves in the bank’s reserve account. The left over money is remitted to Treasury.

      • Gabriel Forest

        Thank you! So in fact interest rate increases would not cause inflation, since reserves are trapped in the system. Increased reserves with QE has not caused the banks to increase lending, so adding even more reserves would have no inflationary effect on the broad money supply. Unless I am missing something?

  13. The 7V\aestro

    author claims that rate hikes may encourage banks more than ever to create loans….

    i can’t argue with that at all

    but

    as rates go higher, people may start to say “hey that amount of interest is craaaazy” and “that house or car is sooooo expensive per month ” and have less interest in taking a loan at all

    this is deflationary

    high rates are only inflationary if banks can FORCE people/entities to take loans

    • Yaun

      As long as real yields remain constantly negative around where they are now, people will increasingly pile into long term debt like it was a meme stock, even if nominal rates are rising and nominal payments increase. The borrower likes his free money, the bank likes their loan vs deposit spread, it’s win/win, just the depositor has to pay both. It’s a perfect setup for an increase in velocity. This assumes that the FED will stay behind the curve. If they would hike to 10% tomorrow, all of what this blog said would be mute. Nominal rates increases don’t matter, real rates do.

  14. Rob

    I find all this speculation meaningless really without confirmation of how money is actually created. Without a framework of how money itself works, these theories don’t mean much. The seem to cherry pick data with supports the hypothesis, but without understanding the full cycle, all I see are holes.
    When reading this stuff I try to balance it against the dominant theories on money creation and banking, of which there are 3; banks are just financial intermediaries between buyers and sellers, then there is the fractional reserve banking theory (which seems to be the most popular these days) and finally we have the theory, supported by people like Richard Werner that banks simply create money out of thin air. Which ever of these 3 theories matches reality, assuming one of them does, would change how valid the above theory was.

    It was thought provoking though, so thanks for that!

    • Thomas

      Right now the correct theory is theory 3: banks create new money by bookkeeping or adding digits to accounts.

      Also I don’t think any one entity has control over what money is. The scary thing is the thing called money is organic and emerges in new forms all the time.
      Is crypto money?
      Are eurodollars real money?
      Are derivatives money?
      Are shadow bank fintech loans money?

      We don’t really know if lowering interest rates or raising interest rates is ultimately inflationary or deflationary, the MMT view is that lowering rates is deflationary and increasing rates is inflationary which contradicts orthodoxy economics. No one really knows but the Fed has to keep up the facade that they’re in control.

  15. Michel

    Great article, thanks a lot Joseph. Could you explain final outcome for commodities? I did not catch end of article. Will commodities outperform ? And I would include precious metals and cryptos. Thanks

  16. Chris repke

    So if I’m understanding this correctly, paired with a knowledge of recent history, it’s like this: if the fed stands aside and doesn’t buy treasuries, we quickly have a spike in yields and chaos in the repo markets ala 2019. Banks would crater as their asset values implode and we’d have huge deflation. To counter that, the fed has to buy everything in sight to keep rates low. But this leads to persistently low inflation or outright deflation because then the banks won’t expand credit. We go the Japan route. But then since the economy will be weak, and funding costs will be low, the government will spend to infinity. This is inflationary, as long as the central bank will buy the bonds, which from what we saw in 2019, we can only assume they will do. So to achieve the politically desired result of a growing economy, without massive inflation, rates have to stay low so the banks don’t add to it, so the fed has to keep buying. In other words, if they don’t want to allow anything bad to happen, both the fed balance sheet and the government debt MUST grow to infinity together. So our options are catastrophic deflation, runaway inflation, or perpetual debt monetization which in other countries has always eventually led to a crisis of confidence in the currency itself and therefore hyperinflation. And as of today our monetary and government leaders have opted for option 3, hyperinflation. Am I understanding this correctly?

  17. Dot

    I read every article I see on inflation (having come to adulthood during the 70s and suffering a form of fiscal PTSD as a result). I think I follow this logic but there are so many cross-currents it does not appear to be actionable information. Or does it mean buy the banks?

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