The problem with Fed QE—banks just aren’t lending
The funds U.S. banks had available for lending to businesses and households increased last month by $95.8 billion to an all-time record high of $2.3 trillion.
What are the banks doing with that enormous liquidity? The answer is: nothing. Banks simply put that money back where it came from: at the Federal Reserve (Fed). They chose the Fed deposits paying 0.25 percent, instead of earning 4.5 percent on new car loans, or 10 percent on two-year personal loans.
Before taking up the issue of banks' feeble and apparently reluctant consumer lending, let's step back and see how extraordinary this flood of Fed's credit creation is. In the period immediately preceding the financial crisis – i.e., all of 2007 and the first half of 2008 – these funds (also called excess reserves) banks deposited at the Fed fluctuated around monthly averages of $1.5 billion and $2 billion (sic).
(Read more: Jobs shocker may force Fed's hand)
Since that time, the Fed has been managing one of the worst financial crises in U.S. history, creating money against massive asset purchases in order to recapitalize the ailing financial system and to support the recovery from the Great Recession.
Both tasks have been accomplished with varying degrees of success.
The fact that the recourse to the Fed's discount window is now back at levels seen for most of 2007 indicates that the financial system has been largely stabilized. We shall soon know more about that because the Fed intends to conduct another round of tests to check how much the current recapitalization process can shield the system from a variety of future shocks.
Dysfunctional financial intermediation
The economy, however, has responded less well to the Fed's exceptional credit easing. In its third year of recovery, the economy was still operating in the first nine months of this year at an average annual growth rate of 1.5 percent – about half its widely presumed noninflationary growth potential.
Weak bank lending is an important reason for this slow and sluggish cyclical upturn. With the interest-sensitive sectors of the economy accounting for 83 percent of aggregate demand, it is clear that the proper funding of private consumption and business investments holds the key to a sustained take up of huge human and capital resources which currently remain unused in the American economy.
And that is where the problem lies: the linkage between the Fed's Herculean efforts to keep pumping the liquidity and the banks' lending is not working. Data published last Thursday (November 7, 2013) show that bank loans to consumers – accounting for 40 percent of all lending to households – slowed down in the year to the third quarter to an annual rate of 3 percent.
(Read more: Fed could be about to make a major policy change)
In case you are wondering whether that dismal number could also be a result of a weak loan demand by households, think of the fact that, over the same period, non-bank lending to consumers accelerated slightly to an annual gain of 8.23 percent. Clearly, finance companies, credit unions, etc., are stepping in where banks seem unwilling to tread.
What we have here is a case where the transmission channel between the monetary policy and the real economy is clogged up. Instead of financing aggregate demand, the liquidity created by the Fed is being deposited by the banks back at the Fed at an interest rate of 0.25 percent.
The obvious question is: what is the Fed doing to repair, and restore, this dysfunctional process of financial intermediation?
Don't blame the banks
They may be doing something, but I don't see anything. All I read is an untimely and irrelevant guessing game by various Fed officials about the level of short-term interest rates at which they won't be able to serve banks' interest income on huge, and rapidly growing, excess reserves they hold at the Fed. And that is when the Fed is not berating the banks for all sorts of their alleged misdeeds.
That is unfortunate. At this point in the U.S. business cycle, a readily available and reasonably priced credit is crucially important because other determinants of household and business spending remain very weak. An unemployment rate of 7.3 percent, and the job insecurity it breeds, are serious impediments to consumer and business outlays. And so is a small, 0.9 percent, increase in the real personal disposable income during the first nine months of this year.
Under these circumstances, households are unlikely to draw down their savings balances to finance current consumption and maintain their customary lifestyles. Quite the opposite, they would be more inclined to pay back their loans and save – a behavioral feature one can deduce from a relatively stable average personal saving rate of 4.4 percent so far this year.
(Read more: Taper tease? Market worries Fed will end easing)
That cautious consumer mood is also reflected in household surveys. At the beginning of this month, some preliminary readings show consumer confidence falling to its lowest level since December 2011.
What is the way out of this?
As always, solutions have to come from appropriate monetary and fiscal policies.
Given that the fiscal policy is on automatic pilot, the Fed has a difficult task of finding a properly balanced policy mix. Whether such a judgment call is well served by a continuation of an extraordinary monetary easing is debatable, but it is absolutely certain that an expansionary credit policy is a correct response to Washington's indiscriminate and excessive fiscal tightening.
That is the policy mix we now have, and the one likely to remain in place for some time because budget issues have become hostage to seemingly unbridgeable political differences that will drive Congressional mid-term elections next year and presidential elections in 2016.
My guess is that the lingering uncertainties this will continue to generate will not be conducive to stronger consumption and investment spending.
(Read more: By not tapering, Fed actually increased stimulus)
But don't blame banks for that. They did not create these problems; policy makers did.
With every loan banks write, they are taking an investment decision whose expected income stream should be profitable. The fact that banks now apparently consider that their risk-adjusted return on consumer loans are lower than the 0.25 percent deposit rate at the Fed is a serious indictment of the monetary and fiscal policies they have to contend with.
Follow the author on Twitter @msiglobal9
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.