Fed Up, Again: Steve Hanke on why near-zero Fed rates are causing a credit crunch

In a new piece called Fed Up, Again economics professor Steve Hanke makes his case for why the Fed must hike hike overnight bank-to-bank rates from .25% to 2% in order to end the credit crunch their existing low rate policy has caused. Below is an excerpt explaining the concept clearly using retail bank lending. The piece was recommended by a friend of The Basis Point who’s got plenty of his own rate research.

While the Fed has pumped huge quantities of liquidity into the economy, the U.S. is paradoxically facing a credit crunch.

As the accompanying chart indicates, banks have utilized their liquidity to pile up cash and accumulate government bonds and securities. In contrast, bank loans have actually decreased — a credit crunch.

To understand why, in the Fed’s sea of liquidity, the economy is being held back by a credit crunch, we have to focus on the workings of the loan markets.

Retail bank lending involves making risky forward commitments. A line of credit to a corporate client, for example, represents such a commitment. The willingness of a bank to make such forward commitments depends, to a large extent, on a well-functioning interbank market — a market operating without counterparty risks and with positive interest rates. With the availability of such a market, even illiquid (but solvent) banks can make forward commitments (loans) to their clients because they can cover their commitments by bidding for funds in the wholesale interbank market.

At present, the major problem facing the interbank market is the zero interest-rate trap. In a world in which the risk-free Fed funds rate is close to zero, banks with excess reserves are reluctant to part with them for virtually no yield in the interbank market. Accordingly, the interbank market has dried up — thanks to the Fed’s zero interest-rate policy — and, with that, banks have been unwilling to scale up their forward loan commitments.

In short, the Fed’s zero interest-rate policy has created a credit crunch that is holding back the economy. The only way out of this trap is for the Fed to raise the Fed funds rate to, say, two percent. [read more…]