Liquidity Glut or Credit Crunch?

Birgit Figge, DZ Bank, Frankfurt.
This article appeared in the March 2009 issue of Current Economics with permission of the author.

Key Concepts: Credit Crunch | Liquidity Injections | Deflation | Inflation |
Key Economies: United States | Euro zone |

Two scenarios for the international financial markets are currently the subject of heated debate. Some market participants see the danger of a tightening of the credit supply in the United States and/or the Euro zone that will trigger a general deflation or at least generate deflationary symptoms. The rest of the market is focusing on the immense volume of liquidity that the central banks are currently pumping into the market. These players see the simultaneous expansionary bias of monetary and fiscal policy worldwide as potentially triggering an inflationary spiral.

The pattern of yield changes over the recent months shows that the bond market is in a state of tension, torn between growing concerns about deflation in the short term and the expectation that expansionary monetary policy and rapidly growing budget deficits will generate rising inflation in the longer term. In the United States, the yields on ten-year US Treasuries fell to 2% in December, only to rise to 3% at the beginning of the year. In the Euro zone, ten-year Bund yields have climbed from their low of just under 2.90% at the end of December to about 3.40% at the beginning of February. At the moment the ten-year yields are falling again.

Neither of the diametrically opposed concerns, inflationary and deflationary spirals, can be dismissed out of hand in the current environment. This short study will briefly discuss both mutually exclusive trains of thought. What conditions will cause inflation or deflation to actually materialise? As the scenarios referred to would massively impact the government bond markets, the likely effects on bond prices will be at the center of our analysis.

Possibility 1: Opening the Flood Gates of Liquidity

The expectation of surging government bond yields is based on the assumption of a massive rise in inflation. There is even talk at the moment of the threat of hyperinflation. These concerns are based on the massive amount of liquidity that the central banks are currently pumping into the market. Many also see a danger of the monetisation of sovereign debt. Historically, high inflation has always followed when the central bank has taken over the financing of government debt and has printed “new” money to do so.

If we get increasing evidence in the coming months that points to an acceleration of the rate in inflation, then yields will shoot up, especially at the long end of the curve. In this scenario the central banks will not be able to delay for long and in order to contain the risk of inflation they will have to raise their key interest rates quickly and substantially. This would lead in turn to large falls in price along the whole of the yield curve.

Even though it poses a potential threat to price level stability, the central banks are currently left with no choice other than to supply the markets with liquidity. The lack of willingness among the banks to lend money to each other has landed several United States and Euro zone financial institutions in a liquidity crisis. In order to bridge these gaps and mitigate the effects of the recession, the central banks are flooding the markets with astronomical sums. Flooding the markets with money is basically only possible if the central banks turn on the printing presses.

US and Euro zone yields (10 years)
US Treasury yields and German Bund yields
Source: Datastream  

Given this background, it is no wonder that many of the monetary variables used by both academics and practitioners to analyse inflation risks an immediate danger of rising inflation. A prominent example we have to cite is the monetary base (also money base, narrow money). This comprises the minimum reserve, excess reserves and cash in circulation. But increasing the monetary base does not increase the supply of money to the economy by the same amount. If the commercial banks extend loans and the non-banks draw down loans, the money creation multiplier increases the “working” money in the economy as a whole many times over.

The charts below show that the monetary base in both the United States and the Euro zone has increased sharply. In the United States this has taken place explicitly through the policy of “quantitative easing”. The Fed buys securities from the commercial banks and it extends loans to specific sectors of the economy. For example, the Fed has already extended a loan to insurance giant AIG. The Euro zone monetary base has been expanded particularly through open market operations. Towards the end of last year for instance, the monetary watchdogs decided to grant the commercial banks their full allocation when they tendered for financing.

The risk of inflation in the market is primarily due to the increase in the monetary base. But does this money in fact enter into economic circulation? Creation of central bank money is only having a limited effect currently because the commercial banks are parking a large part of the central bank funds available to them back with the central bank. This means the credit balances that the commercial banks deposit at the central bank are over and above the statutory minimum requirements. The Fed has been paying interest on this money since October 3. The Euro zone commercial banks mostly park their “surplus” money overnight in the deposit facility as a rule because this pays better interest than the excess reserves. The commercial banks had been parking an increasing amount of liquidity with the European Central Bank (ECB) overnight, especially since the ECB reduced the spread between its deposit facility rate and the refi rate from 100 basis points to 50 basis points on October 15, 2008. The volume has fallen back again since the ECB increased the spread again. The deposit facility interest rate has been 100 basis points below the prime lending rate again since January 21..

Monetary base of the United States Monetary base of the Euro zone
Monetary base of the United States Monetary base of the Euro zone
Source: Bloomberg Source: Bloomberg

The surplus liquidity is in itself lendable money that the commercial banks could pump into economic circulation. The multiplier effect could cause the money supply or other monetary aggregates to actually increase more rapidly. At present however, this money is being left at the central banks, which has the effect of contradicting central bank policy. The money supply provides an indication of how much money is actually feeding through to the economy. It is true that money supply growth has speeded up in the past few weeks and months, but at the same time the money multiplier — the leverage effect — has fallen. The United States money multiplier for the narrowly defined M1 measure of money supply is currently below one. The money supply has therefore grown at a slower rate than the monetary base. The situation in the Euro zone is similar. Part of the immense volume made available by the ECB is getting through and reaching economic agents. However, the fact that the money multiplier has fallen over the past few months tells us that the money supply has not increased by anything like as much as one would have expected on the basis of past experience (i.e. if the money creation multiplier has stayed constant).

Excess reserves at the Fed since August 2008 Deposit facility at the ECB since October 2008
US Fed excess reserves ECB deposit facility
Source: Bloomberg Source: Bloomberg

What needs to happen for this money to actually come into circulation and thus into the pockets of economic agents? The stimulus provided by the central banks when there is an increase in the monetary base depends on the overall economic climate and the behavior of economic agents. The uncertainty over the economy needs to diminish so that companies and households display less caution and increase credit demand. Financial and credit institutions will only draw down all the money available from the central bank when economic agents apply for loans. Then money creation can get underway as companies, the public sector and individuals take up loans from the commercial banks. As a rule however, economic agents will only take on credit if they consider their economic situation to be robust. In summary, the demand side — the demand for credit — can stimulate money creation. This will presumably happen when economic uncertainty starts to recede. However there is another prerequisite for credit expansion: the banks must also be prepared to extend new loans!

Possibility 2: Credit Crunch — Banks Stop Lending

It is right here that the deflation advocates’ chain of argument starts. They are afraid there is going to be a credit crunch. What exactly does this mean? A credit crunch (squeeze, tightening) is deemed to have occurred if the banks’ poor financial situation forces them to restrict lending. A characteristic of a credit crunch is that a potential debtor who is willing and capable of meeting his loan obligations, still cannot get a loan. Credit crunches generally make already difficult macroeconomic situations worse. By way of rising unemployment and unused capacity, they can set off a deflationary spiral. Yields will then fall massively. Many central banks will try to bring this crisis under control by following the example of the US central bank and aiming for a zero interest rate policy. This in turn reinforces the fall in prices on the government bond market.

USA: Money supply growth M1 and M2 USA: Money multiplier M1
M1 and M2 money supply in the United States M1 money multiplier
Source: St. Louis Fed Source: St. Louis Fed, NBER, DZ Bank
Euro zone: Money supply growth M1, M2 and M3 Euro zone: Money multiplier
Euro zone money supply growth Euro zone money multiplier
Source: Bloomberg Source: Bloomberg, DZ Bank

The main cause of a credit squeeze is the restriction of lending by the commercial banks. This definition does not automatically cover any and every reduction in the demand for credit. This therefore creates a problem when speaking of a credit crunch in the current context: a fall in lending is easy to identify; however, the cause of it is very difficult to establish. This is because it is very difficult to isolate credit demand from credit supply.

Japan provides the archetypal example of a credit crunch. The bursting of the property and stock market bubble at the beginning of the nineties led to the so-called “lost decade”, characterised by stagnation, deflation, a banking crisis and enormous national budget deficits. The regular Tankan surveys showed that the banks were much less willing to extend credit from the middle of 1997 onwards. The actual recorded collapse of lending came later, due to a time lag of three to four quarters. GDP growth slumped at the beginning of 1998. The chart below demonstrates the high correlation between credit supply and economic growth. Can a similar situation occur in the United States or the Euro zone?

Japan: Lending conditions and lending Lending and gross domestic product
Lending conditions in Japan Japanese lending relative to GDP
Source: Datastream Source: Datastream

The outbreak of the current financial crisis has demonstrated that a high level of bank leveraging can destabilise the entire banking sector. The banks are trying to reduce their debt in response to the current problems. This deleveraging effort comes on top of regulatory requirements; credit institutions have been called upon to significantly increase their capital ratios. They have three options to achieve these objectives: firstly they can raise external equity capital. Currently, there are limits to their ability to do so in the context of the financial crisis, since no private investors are willing to act as capital providers to banks at present. This source of funding has effectively dried up, especially since the second escalation of the crisis towards the end of last year.

A second option for furthering the debt reduction or deleveraging process is to sell securities. Banks have been turning to this solution for several quarters. Historically, this approach is associated with the risk of a dangerous spiral. Sometimes the market has got flooded with so many securities that it has experienced the deleveraging paradox. The more securities they sold, the bigger the write-downs the banks had to make. This in turn reduced their return-on-equity ratios, which forced the banks to sell more securities to strengthen their equity capital base — completing a perfect vicious circle.

A third way of reducing banks’ debt is for them to stop issuing loans and stop renewing loans. While there is no doubt that this deleveraging approach takes a long time, it does allow banks to permanently reduce their debt and strengthen their equity capital base. It is apparent that banks have been using all three approaches simultaneously over the past few months and quarters. Nevertheless, their primary reliance on restricting credit could have far-reaching negative effects on the wider economy.

Net percentage of banks intending to tighten lending standards
Intentions to tighten lending standards
Source: ECB, Fed  

Credit supply is the key determinant of economic growth. The Fed’s and the ECB’s quarterly surveys show that the possibility of a credit crunch cannot be dismissed out of hand. The central banks ask the commercial banks to say whether their credit standards are tighter, easier or unchanged since the last survey. The findings are unequivocal and alarming.

How should we see the relationship between lending and deflation? A clampdown on lending by the banking sector has the potential to trigger deflation. If consumers are unable to get loans, they restrict their (credit-financed) consumption. Companies are forced to rein back their investment when credit is tight — all the more so if capital-market funding is also harder to access. Increased saving leads to capacity underutilisation, especially following long consumer booms. This has a negative impact on the corporate sector because earnings fall. This causes companies to cut staff. Job insecurity and fears for the economy result in further panic saving.

United States: Lending increasing more slowly Eurozone: Lending to residents
Lending rate in the United States Lending rate in the Euro zone
Source: Fed Source: ECB

Once a country is suffering from deflation, the danger of a self-reinforcing trend is very great: falling prices sharply reduce consumers’ propensity to spend since they see the prospect of even cheaper prices. Falling demand in turn reduces the utilisation of production capacity further leading to steeper falls in prices. The end-result is a negative spiral driven by consumer reticence, unemployment, falling net wealth and falling prices. Deflation is frequently accompanied by a fall in the money growth and/or the velocity of money. Even reducing the official interest rates could fail to work in this context if lending became too risky for the banks to want to extend new loans. In addition to this, deflationary periods have a pronounced tendency to be lengthy.

The relationship between inflation and lending can also be clearly shown statistically. Regressing total lending year-over-year with a time lag of two months as the explanatory variable and the core inflation rate as the response variable, identifies a significant correlation. The simple regression is 51 % determinant. We deliberately chose to analyse the core rate because it is not distorted by oil and food prices, which are volatile components. As credit growth is only the reverse of money supply growth, the close relationship between the core inflation rate and credit growth comes as no surprise.

Relationship between credit growth and inflation
Relationship between credit growth and inflation
Source: Datastream, DZ Bank  

Summary: Deflation and Inflation

How should the contradictory theories be judged? If we are honest, we have to admit that the deflation and inflation outcomes cannot be simply ignored as negligible risks, however contradictory they may currently appear. The impact on the bond markets would be extreme in each of the economic scenarios we have outlined. In the event of inflation there would be a dramatic yields surge, while yields would fall to new lows if the deflation scenario materialised.

The deflation risk appears to be the greater threat near-term. Lending has fallen sharply again, especially after the failure of Lehman Brothers. The banks themselves are currently saying that they intend to tighten their lending criteria because of their past write-downs and their need to prioritise deleveraging. However, credit provision by the commercial banks is the backbone of the wider economy since it drives money creation. This is precisely what is not happening at present, as we know because the M1 money creation multiplier in the United States is currently below one. The central banks’ huge-scale pumping of liquidity into the market is coinciding with an increasingly sclerotic supply of money from the banking sector. Although we cannot rule out deflationary tendencies and symptoms in the current environment, we see a low probability of a self-reinforcing deflationary trend — i.e. a vicious downwards spiral. The central banks, led from the front by the US central bank, have mostly moved quickly to highly expansionary monetary policy stances. Quantitative easing should prevent deflation in the United States specifically, especially since the central bank has already announced it will sell US Treasuries if necessary.

While out of the question short-term, the current monetary and fiscal policy stance could trigger a surge of inflation in the medium term if the central banks wait too long to throw the liquidity lever into reverse. Closer analysis of the measures currently being carried out shows however that the central banks are unlikely to fail to drain off the market’s immense liquidity in time. For instance, the Fed is mainly buying in securities for a limited time. The current hold is 84 days. In fact, the Fed will only keep the bulk of the securities it is buying right now for 30 days. This gives the Fed a mechanism to withdraw liquidity from the market at a very rapid rate. The US central bank did not buy any asset-backed securities in January for example, an omission that directly reduced the monetary base by US$ 200bn. The Japanese example and the currency conversion following the reunification of Germany both demonstrate the flexibility that the central banks have to withdraw liquidity quickly and efficiently from circulation. Assuming that the central banks will drain liquidity from the market on the smallest sign of any uptick in inflation when the economy recovers, a significant medium-term inflation surge should be avoidable.

The industrialised countries are still a good way from either of these extreme scenarios. Despite the recent dip, year-on-year credit growth is still comparatively high both in the United States and in the Euro zone. We can identify certain factors that need to be monitored more closely in the near future, however. To detect the danger of inflation at an early stage, the monetary base, the multipliers and money supply growth indicators all need to be watched. To gauge the risks of deflation, the most important thing is to monitor total lending.

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