Confidence is making a comeback, and that's important because this recovery has been the weakest ever and the most risk-averse ever. Since last June, sharply lower oil prices have given a big boost to confidence, as I pointed out last week. Now we have the evidence of a substantial increase in bank lending, which reflects increased confidence on the part of banks and borrowers (banks more willing to lend, borrowers more willing to borrow). That's good, because easier access to credit can translate into more investment, more jobs, and more productivity. But there's an often-overlooked downside, which I pointed out one year ago. Increased confidence which results in more lending and more borrowing can eventually tip the supply/demand balance of monetary policy in an inflationary direction if the Fed doesn't react in a timely manner to a reduced demand for money.
Increased lending is indicative of a decline in the demand for money, because borrowing is the opposite of accumulating money. That's important because the demand for money during the current recovery has been extraordinarily strong, and that was what prompted the Fed to engage in Quantitative Easing. QE allowed the Fed to accommodate a huge increase in the demand for money and for safe assets by transmogrifying notes and bonds into bank reserves, which are functionally equivalent to short-term T-bills, the world's safe asset of choice. The monumental increase in bank reserves failed to spark any increase in inflation because banks wanted those reserves, and had little or no desire to use them to support increased lending. Banks preferred to lend money to the Fed, even at paltry interest rates, than to lend money to the private sector. As I've noted before, banks lent substantially all of their deposit inflows to the Fed, rather than to households and businesses.
Now, as the demand for money and safe assets recedes, the need for QE not only disappears but begins to reverse. Sooner or later the Fed will need to accommodate declining money demand by shrinking its balance sheet (i.e., by selling its store of notes and bonds in order to pay off the money it has borrowed from the banking system) and/or by raising the interest rate it pays on bank reserves. If banks today are willing to lend more (at a rate which far surpasses what they can earn by lending money to the Fed in exchange for bank reserves), then they are at the same time less willing to hold a huge supply of excess bank reserves which pay only 0.25%. The excess reserves of the banking system are now about $2.6 trillion (see chart above). Interest paid on reserves (IOR) might need to be quite a bit higher than today's 0.25% to keep banks interested in holding billions of excess reserves and not over-lending to the private sector.
Now let's look at the facts:
Total bank credit for many years rose at a little over 8% a year. That changed completely in the wake of the 2008 financial crisis, when bank lending virtually ceased. Banks were extremely reluctant to lend, and businesses were extremely reluctant to borrow, with many businesses and households preferring to deleverage instead. It was all the result of a collapse of confidence in the future, and a fear that another global collapse lurked just around the corner.
A closer look at the recent past (see chart above) shows that the pace of bank lending started picking up about one year ago. In the past year, bank lending has increased 8.2%, and over the past three months, bank lending has risen at a 10.6% annualized pace, by far the fastest pace since the Great Recession. Bank credit has increased by $840 billion since early January 2014. That's some serious money creation.
About one-fourth of the increase in bank lending has taken the form of direct loans to small and medium-sized businesses (see chart above). C&I Loans are up over $200 billion in the past year, for a 13.5% increase. Through their ability to lend, banks can create money, and they are doing it in spades. The Fed has enabled banks to lend virtually without limit through its ample provision of bank reserves.
In its classic formulation, inflation happens when the supply of money exceeds the market's demand to hold that money (think "too much money chasing too few goods and services"). Until recently, despite flooding the banking system with reserves, there was no unwanted increase in the money supply; banks were happy holding mountains of excess reserves and increasing their lending activity at a modest rate. Now they are less happy holding tons of excess reserves paying a paltry 0.25% and have stepped up the pace of lending. This is the first step in what could prove to be an over-supply of money and a subsequent rise in inflation. It might take 6-12 months before this shows up in the inflation statistics, but in the meantime it bears close scrutiny and argues strongly for caution when deciding whether to hold Treasuries at today's historically low interest rates. Rising confidence implies faster growth, and, in today's post-QE world, the threat of rising inflation. Both spell bad news for Treasuries.
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