If you’re directly involved in real estate (and most of us here are), you’ve probably spent the last several months agonizing over interest rates. It’s possible that you’ve been taking some time away from investing.
Maybe take some extra time to grind the old nine-to-five, take the family on summer holiday, raise cash, and wait for the financial storm to pass. Maybe you’re hanging out in one of those high-yield savings accounts I keep seeing ads for, which are paradoxically both boring and exciting at the same time.
What do interest rates mean? Rates are the “price of money,” or the intersection of what borrowers are willing to pay later to access money now and what savers are willing to accept later for that money.
Push-Pull
We think of rates as the sort of antagonist to economic activity located underneath the surface of the real economy. When rates are low, money is considered to be “easy” and abundant. When they’re really low, people will even jokingly refer to the money as “free.”
Inversely, when rates are high, we consider money to be “tight.” Businesses can’t afford to borrow, which means they can’t invest in new projects or employ more people. Monetary flows are choked and strained. This is the common understanding of money.
In fact, it’s so much the common understanding of money that interest rates, or more specifically, interest rate policy, have been the most important consideration in financial markets for a long time. This is largely attributed to Alan Greenspan, Federal Open Market Committee chairman from 1987 until 2006. The economy performed exceptionally well under his leadership through his dual use of interest rate policy and public relations (not in that order).
Greenspan’s facile command of markets earned him the nickname “maestro” and solidified the Fed’s reputation as a sound technocratic institution. Fed controls rates. Rates control markets.
It was laughably simple and made monetary policy into a sort of game. Inflation perks up? Raise rates, effectively putting the brakes on the economy until it cools back down. Unemployment gets a little high? Lower rates to provide monetary stimulus, boosting the economy back to normal.
This refers to what’s called the Phillips Curve. Monetary scholarship was becoming more and more convinced of what was referred to as an “exploitable Phillips Curve,” more simply, the idea that policy changes could be used to move an economy along the curve as desired.
Consider money from another point of view, however. As we know from previous articles in this series, money is created through the process of fractional reserve lending. Banks take in deposits from customers and then turn around and use them to originate loans to borrowers. A deposit remains on record as belonging to the depositor.
But this money gets re-loaned in the form of currency in someone else’s hand. It’s literally double-counted (or more).
In short: Most created money is not “printed” by the Fed or the U.S. Mint. Most money is loaned into existence by banks. That’s a fairly easily understood concept. What’s commonly missed is the corollary that’s implied by that: If money is created when it is loaned into existence, then it is destroyed when it is paid back. Therefore, if loans are being originated at the same rate at which they are being repaid, then the quantity of money is stable.
So when the Fed brings interest rates lower, we understand that it’s part of an effort to encourage lending. What’s often not considered is that when loans are originated at low rates, they are amortized faster than when they’re originated at high rates. This should be intuitive to anyone with a mortgage. Whatever money is created is also repaid (destroyed) faster.
Alternatively, consider high rates. High rates purportedly mean the economy is seizing from a lack of liquidity.
However, the alternative explanation is rarely considered. If the market confirms high interest rates, that indicates that there is high-yielding economic activity to engage in. That promises to spur a lot of monetary growth.
In that sense, high rates are a good indicator. The alternative explanation for low rates is that there are simply not very many high-yielding opportunities available for businesses to take advantage of.
Who’s in Charge Here Anyway?
Look back to the beginning of the global financial crisis. In July 2007, rates started to back off from the Fed’s target rate of 5.25%. The Fed responded by bringing rates down a couple of months later. Rates coasted lower.
Rates continued to fall, and the Fed continued to chase them lower. They declined through the failure of Bear Stearns in March 2008. Then, Lehman Brothers declared bankruptcy in September 2008.
Around December 2008, rates would settle to a miserable 0.16%. The Fed capitulated and brought its target down to a range of 0.00% to 0.25%. Rates would barely budge for more than half a decade—at effectively 0%.
There was something about rates that the Fed was missing. And they were aware of it.
Or, more recently, we can take United States Treasury Securities. As the Fed has raised its target rate over the past couple of years (now to 5.5% on the upper bound), we find that markets don’t especially care what the Fed is doing.
And that’s because the federal funds rate is just an overnight lending rate. It doesn’t directly apply to economic activity. It will typically influence the yields on shorter-term U.S. Treasuries (two-year maturity and shorter).
Those are the terms in which bank finance is conducted. Once you get into the three-year and five-year Treasury Notes and longer, you start to see that yields go back down. Why?
Markets are concerned about another downturn. Business finance is commonly done on a term of between 36 and 120 months. This portion of the U.S. Treasury curve is what’s colloquially called “the belly” of the curve. This part of the curve is probably the most informative from a productivity perspective.
Today, businesses are sort of telling us what banks were telling us back in 2008: They simply don’t have the appetite to take on debt at higher rates. The banks can lend short-term to each other all they want at ~5.5%.
What you would expect is for businesses to be borrowing in the medium term at even higher rates. After all, those businesses would be borrowing for a longer period of time, so the banks would want a higher interest rate to compensate; this is a phenomenon known as “term premium.” But evidently, firms won’t play ball unless they get their way.
Unloaned, Unseen
Where else is this seen? As far back as the data series will go, the banking system never really held excess reserves. There was always somewhere for money to be deployed. If one bank didn’t have a lending opportunity on a given day, it knew another one that did and could lend its reserves to it to participate indirectly.
What was the result? Excess reserves existed in trace amounts only. For visibility, the line on this graph has a higher width.
Post-2008, the banking system no longer seems to have a use for its reserves. Holding them in the trillions previously, they were gobbled up by eager borrowers.
“But rates have gone down! It’s an easy money environment!” the detractors cry.
The rates for loans that are originated have gone down. The money that wasn’t loaned wasn’t seen. In the post-2008 economy, lenders have been unable to find safe opportunities to make good loans.
The problem has nothing to do with interest rates. The banks are awash with reserves, with nowhere desirable to put them. The result is a greater pool of reserves, all competing for a smaller pool of qualified borrowers. The supply of funds is higher, and the demand for funds is lower, which means the interest rate becomes more competitive.
Big Bank, Small Bank
And this data is very clearly reflected in the banking industry. When looking back about 15 years, we see that large banks have been helping themselves to market share from the regional and community banks.
In fact, this effect is so strong that community banks have been disappearing. Today, there are about half as many as there were 20 years ago.
And this makes sense. Smaller banks do proportionally more work with local borrowers. They are closer to the real economy—more Main Street than Wall Street.
Meanwhile, the larger banks tend to write higher-volume loans for more established firms or even just for other banks. The regional and community banks are the ones who have been not-writing the not-loans we’ve been talking about.
The Bottom Line
So what’s the takeaway here? The Federal Reserve presents to us as if it has control over the volume of money, as well as interest rates. But the data demonstrates that what they actually have is tenuous control over a narrow portion of both rates and money. They can manipulate near-term rates, and they can provide bank reserves. But we can see that there’s a clear disconnect between those factors and the real money that circulates throughout the economy and impacts prices.
So, what does control money throughout the real economy? If banks are flush with cash reserves, why are they seemingly unstable? What happened in 2008? What has the Fed been missing?
I’ll address these questions in my next article.
This article is part of Dan’s “Great Update” series, where he explores the world’s new monetary order and digs deep into the who, what, where, and how our global economy has been shaped.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
