The Fed embarked on multiple stimulus efforts in the wake of the 2007-2008 financial crisis. In addition to lowering the Fed Funds Rate (FFR) to near zero, the Fed embarked on something termed Quantitative Easing. Essentially, this involved direct large-scale purchases of various assets, with the goal of controlling even long-term interest rates.
The purpose of all of this was to encourage banks to lend, thereby stimulating the economy. After all, low interest rates should encourage investment and entrepreneurship, which in turn would lead to a more robust economic climate.
But Where Did It All Go?
This week, however, the St. Louis Fed released some very interesting information featuring the concept that it hasn’t completely played out that way. Take a look at the graphic below.
In the right-hand bar (2017), notice the 11% allocation to Cash and Reserves. In combination with Treasury Securities, these comprise some 14% of the overall asset composition of depository institutions. Now take a look at 2007. You can quickly add up the listed values and come up with 98%, meaning that Cash & Reserves and Treasury Securities comprised no more than 2% of the overall total.
Now look at that huge bar in the middle, Loans and Other Securities. Over the 10-year span, it has actually decreased from 73% to 63%. In short, it turns out that very little of that stimulus has been plowed back into the actual economy.
Why would this be the case? The next graphic offers an interesting reason.
That violet-covered line represents Interest on Excess Reserves (IOER). What is that? Simply put, in October 2008 the Fed began paying interest on banks’ reserve balances. In theory, the interest banks received from other lending activity should be higher than that. After all, why would a bank lend out funds at a rate lower than what it could get from the Fed; effectively a guaranteed return?
And yet, the graphic displays quite clearly that this is not the way things have played out. As it turns out, the IOER ended up effectively being a ceiling on short-term rates. Why would that be? Why would not a bank pump money back into other forms of loans and generate a higher return? In short, the answer appears to be that a combination of elevated risk (due to the fragility of the economy), new regulations, and a level of “guaranteed return” from the Fed combined to produce this result.
What Does This Portend For The Future?
In the present environment, we find the Fed seeking to deleverage their balance sheet in an environment of rising rates. While the stock market has generated fairly spectacular gains in the period since 2007-2008, the million-dollar question is; has the economy matched this? And how will the Fed attempting to deleverage into an environment of rising interest rates play out?
It’s all worthwhile information for investors to digest and incorporate into their personal asset allocation.