A Low Fed Funds Rate Is A Sign That Credit Is Very Tight

Posted: Nov 11, 2020 10:15 AM
A Low Fed Funds Rate Is A Sign That Credit Is Very Tight

Source: AP Photo/Pablo Martinez Monsivais

Every so often it makes sense to lead with the obvious. Credit is very tight. Exceedingly so. Evidence supporting this claim is the low Fed funds rate.

The Fed is a rate follower as opposed to a rate setter. Central planning failed in murderous fashion in the 20th century, so to believe as some do that the U.S.’s central bank plans the cost of credit in the 21st is just silly.

The banks that the Fed projects its well overstated influence through set interest rates, and the Fed follows. That interest rates are so low signals difficult credit conditions. Think about it.

Banks are only willing to lend at low rates of interest because they’re only willing to take the most limited of risks. In short, banks are lending to the big, well-established and well-collateralized.

If, on the contrary, they were aggressively lending to riskier business and ideas, higher interest rates would reflect “easier” credit. Banks would pay more for deposits precisely because they would earn higher rates of interest on riskier loans.

That they’re paying so little for deposits is a signal that they’re once again only lending to sure things. The paradoxical truth is that low rates of interest signal tight credit conditions.

This is a useful backdrop in consideration of the Fed’s announcement last week that it would keep rates “steady.” Implicit in such an announcement is really a statement of the obvious: the Fed can’t influence credit conditions in the way that all-too-many assume. The Fed will remain “steady” simply because banks will steadily continue to search for safety.

Crucial here is that the Fed can’t alter the on-the-ground reality of tight, risk averse credit. Really, what would it do?

Naturally Jerome Powell talks about using bond purchases to allegedly influence rates, but such actions are meaningless. Every borrower is going to be charged a different interest rate precisely because every borrower is different. Low rates once again signal that sure things will find credit rather cheap and easy, but that would be true even if market rates of interest were high.

As for riskier borrowers, including entrepreneurial types capable of moving the growth needle, no amount of Fed fiddling will improve credit conditions for them. Assuming availability, it’s going to be expensive; assuming there are loans available at all. Frequently with entrepreneurial concepts the only option is equity financing.

Which means the Fed’s actions are once again meaningless. The Fed can’t create economy-boosting economic growth with “easy credit” as much as economic growth logically makes credit easier. Fed officials and those who follow the Fed get the nature of credit backwards. They do because no one borrows money; instead they borrow what money can be exchanged for. When an economy is growing, the growth signals an increase in production that leads to more lending.

Repeat it over and over again. Economic growth boosts lending as opposed to lending boosting economic growth.

Which is why Powell’s other suggested idea for increasing economic growth is so hard to take seriously. He calls for “fiscal policy actions” to enhance economic output. Translated, Powell seeks more government spending. This fails in numerous ways, but with brevity in mind, two will be mentioned here.

For one, you don’t solve a problem of slow growth with more central planning. In Powell’s case, he’s asking Nancy Pelosi and Mitch McConnell to boost economic activity by them arrogating to themselves greater power over the allocation of scarce resources. There’s no such thing as government spending; rather there’s politicized allocation of resources always and everywhere created in the private sector. As a rule more government spending limits economic growth given the basic truth that politicians aren’t as effective as the market-disciplined when it comes to pushing precious resources to their highest use.

Powell would respond, and economists would nod their heads, that government spending boosts GDP. It does, which is just more evidence of what a worthless number GDP is. This speaks to the second problem.

Governments don’t create growth as much as they have money to spend insofar as they can borrow from past or future growth. That they can is just more evidence that government spending is an economic depressant. Indeed, since governments can only spend insofar as growth has occurred, or will occur, the latter is a signal that any GDP increases as a consequence of government spending are merely evidence of double counting. The growth already occurred, or will occur; hence the spending. No reasonable person would count the harvesting of growth that did or will occur as evidence of more growth.

In short, Jerome Powell misunderstands the Fed’s power, along with the power of Congress to stimulate prosperity. Neither can. Both are consequences of actual economic activity in the private sector, which means both are drags on actual prosperity.

Congress is a legend in its own mind, as is the Fed. The latter is just a reminder that Congress outsources some of its activities to other arms of government. For Powell to believe that either can alter economic reality brings new meaning to naïve.

This article originally appeared on Forbes.com.