Pushing On A String?

Is The Fed Too Easy Or Too Tight?
There has been much talk recently about the need for the Fed to raise rates to stop rising global inflation. Our work shows that money is still tight, even though the Fed has lowered the Fed Funds rate to 2.00%. The Fed surveys senior bank loan officers about lending practices at banks. This information is gathered through the “Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices”. The Fed conducts this survey quarterly with about 60 large domestic banks, and 24 U.S. branches of foreign banks. The information from this survey is quite interesting in today’s environment. The chart below shows the availability of credit and the cost of credit as shown through the Fed’s survey. As you can see

the credit lending standards have become progressively more restrictive. This is shown by the blue line in the chart. As bank lending standards have grown stricter, the cost of credit has been climbing rapidly (shown by the red line). In fact, the percentage of senior bank lending officers who are raising credit costs to businesses is currently higher than at anytime since the survey began in June 1990. It is interesting that banks have been tightening credit during the same time that the Fed has been trying to ease credit conditions. The chart below shows the cost of borrowing plotted vs the Fed Funds rate during the same period of time (6/1990-6/2008).

The chart shows the expected lags in bank lending costs, but recent developments are an anomaly, since borrowing costs are soaring as the Fed continues to lower short term rates. This implies that the Fed is currently “pushing on a string”. The tool of using rates to control the economy is no longer working as it has in the past. This is an alarming development, because it shows the seriousness of the current credit crisis in the U.S.

The Party’s Over
Over the last few decades the Fed has gained enormous credibility as an institution with the ability to manage our economy out of recessions in a non-inflationary way. The Fed as lender of last resort created the “Greenspan Put”, which meant when things got bad the Fed would be there to make things better. This policy has not, however, been without costs, and has only postponed the inevitable. This led to an incredible leveraging of our financial system, the creation of the shadow banking system, and massive amounts of debt being accumulated by the consumer and guaranteed by our financial institutions. The lax lending standards and cheap credit shown in the first chart during 2005-2007 helped create the debt hangover we are currently suffering. Rising delinquency rates and massive write-down's of loans have created deteriorating balance sheets for our banks and investment banks. They want to forget about the lax credit party that got them where they are today. The Pushing On A String chart shows the party is over. Banks are in no position to party again any time soon. Their hangover is too great. We should expect them to concentrate on re-building balance sheets, by raising capital, deleveraging, and cutting back anyway they can. The thought that money is easy, because the Fed cut short term rates is a misconception. Money is tight and will remain tight until the financial system begins to recover from the excesses of a couple of years ago.