UNLOCKED: Credit Driven Inflation is Already Here
How The Fed Can Stop it
Housekeeping: This is an analytical piece we have been educating ourselves on since last week. It is based on some recent research into credit expansion during Inflationary cycles. The impetus was from the increased flow of credit card applications we started getting again recently. The question we asked was “Why would they do this if they are worried about inflation?” The answer may be, they do not care.
We are not experts in credit markets and Fed plumbing, but feel it was worth getting this out nonetheless. Hopefully you get something out of it.
Overview
The economy is slowing but the question remains if it will slow enough to bring inflation back to livable levels without the Fed needing to raise rates too aggressively, and with that trigger a nasty recessionary crash. Unless real rates are permitted to rise during QT to curtail increasing loan activity, inflation will get a second wind this summer.
Until the Fed ramps up real rates using the balance sheet run-off to do so, and sets IORB very high to curtail lending, inflation will persist even while QT is in full swing.
Either the Fed can kill inflation by inverting the yield curve and stopping loan growth, or it can prevent recession by ignoring inflation. It cannot have it both ways anymore.
QE Was Not Inflationary
Remember when we all thought that QE was inflationary? Remember when we found out it was not inflationary; when the Fed directed its freshly printed money towards equities and real estate? This was also one of the drivers behind Wall Street’s growth at main street’s expense. Fun times.
The result of course was higher, much higher, asset prices. Guess what: it works both ways. If QE was not inflationary; Then it stands to reason QT is not deflationary. This may sound simplistically ironic, but it is actually accurate. Here is why according to an April 20th report by TS Lombard.
QT Is Therefore Not Necessarily Deflationary
The report explains that QT, rather than being deflationary, may actually accompany a credit-driven inflationary spike. How? QT it explains, frees up bank money for loans that would otherwise remain locked up in reserves. This is ZH/ZP stuff, so bear with us a minute while we try to make layman’s sense of it.
When previously locked up bank reserves in QE are made available by QT for loan… they get loaned. The key to how aggressively they get loaned is the rate banks earn on that money while it is unused. What is therefore the opportunity cost for these loans? Hence what rate that money earns while it sits idle matters a lot. That opportunity cost is controlled by a Fed key policy rate called the IORB rate.
The Federal Reserve Board describes IORB:
The IORB rate, or interest on reserve balances rate…. is paid by the Federal Reserve on balances maintained by or on behalf of eligible institutions in master accounts at Federal Reserve Banks. The interest rate is set by the Board of Governors, and it is an important tool of monetary policy. Source
Seems like the IORB is the interest rate that banks get on loanable money they have in account not yet being used for actual loans. It is the opportunity cost for making loans with the money.
If IORB is Not Raised, Banks Will Make Loans
Once freshly unlocked funds (by QT) become available for loans, they become subject to real rates and thus to a use it or lose it kind of opportunity-cost principle. Consequently, Banks make frequently more loans or risk the effects of low or negative real rates themselves. Make sense? Banks have “risk” also.
If that money gets paid a high enough interest rate, then it won’t be used in loans apparently. So, if the Fed truly wishes to keep loan volume down and therefore inflation low, it will use the IORB rate to dissuade lending.
If the Fed doesn’t use the IORB to raise opportunity cost of loaning money out high enough, the supply-side inflation we have will be further fueled by loan-leverage chasing goods again even while stocks drop. Credit-driven inflation will keep total inflation elevated.