Rate Watch #777 Weak Economy. Lower Rates? Monetary Regimes.

May 27, 2011
by Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com

Fundamentals

Personal Income/Expenses:

Personal Income - Month/Month change 0.4 %
Personal Income - Year/Year change 4.4 %
Consumer Spending - M/M change 0.4 %
Consumer Spending - Year/Year change 4.8 %
Core PCE price index - Month/Month change 0.2 %
Core PCE price index - Year/Year change 1.0 %

Income growth is fairly strong but being consumed by higher energy and food costs. In is not that people are buying more stuff but more the case that they are paying more for the stuff they are buying.

The PCE price Index is a measure of inflation which looks only at consumer goods.

Consumer Sentiment increased to 74.3. For the past year this number has unduly been affected by gasoline prices making it, in my view, useless.

GDP:

2nd look 2ndQ2011 GDP was +1.8% - the same as the original.

Looking inside and remembering that GDP=C+I+G+(X-M) (were C=Consumer Spending, G=Government Spending, I=Investments, X=eXports, M=iMports) let's break out the components:

C was +2.2% in the quarter contrasted with +4.0% the previous quarter
I was +3.4%
Federal G was -7.9%
State & Local G was -3.2%
X was +9.2%
M was +7.5%.

Jobs:
Initial Jobless Claims were 424,000. This was above the consensus range and above previous. The 4-week moving average was 438,500.

Corporate Profits:
per BEA (Bureau of Economic Analysis) Corporate profits were +5.8% for 1stQ2011.

Housing:

New Home Sales (for April) were 323,000 which was better than previous and consensus.

NAR Pending Home Sales:
The Month-to-month Index fell 11.6%. The housing market is ill. With prices continuing to fall there is little incentive to buy now. Politicians have insinuated themselves into the market trying to make foreclosures tougher. The effect of that will be to drag out the date on which we start to see recovery in the housing market.

Mortgage Applications:

From MBA (Mortgage Bankers Association):
Purchase Index - Week/Week Change +1.5 %
Refinance Index - Week/Week Change +0.9 %
Composite Index - Week/Week Change +1.1 %

Home Prices:
FHFA (the people who regulate FNMA/FHLMC) House Price Index was -0.3% in March

Durable Goods Orders:
New Orders - Month/Month change -3.6 %
New Orders - Year/Year Change +5.3 %
Ex-transportation - Month/Month -1.5 %
Ex-transportation - Year/Year +6.7 %

DGOs have long lead times. This data says to me that manufacturers were getting ahead of themselves and cut back on durables in April. Economic recovery is perceived as not being as strong as a few months ago. Relevant thereto, 2nd look GDP for 1stQ2011 is tomorrow.

The Technicals

The daily upcrossed to bullish. The weekly is bullish. The technical indications point to a 10-year yield under 3.0%. This dip in yields will be brief. The "sweet spot" will last no more than 2-3 days. Those in the mortgage profession who are trying to time rate locks must read StoMaster (see below) and note when the weekly tech is about to peak and reverse. It is the weekly tech which is most important to mortgage professional given the length of mortgage rate locks.

Jim Grauer (StoMaster) has a description as to how these techs can be used by mortgage professionals and borrowers. The detailed narrative may be found daily at StoMaster. Jim understands the techs as well as anyone whom you may see commenting in the media. He has been doing this for about 25 years and is capable of reading the technical patterns in the context of what they have indicated in the past. Most other technical analysis is much more simplistic.

Analysis

Mortgage rates are down consequent to weak economic news. We will see a resurgence of refinance activity with another dip in rates.

BEA's report that GDP increased 1.8% in 1stQ2011 is based on using the dubious assumption that inflation was an annualized 1.9%. Yet April's CPI-U per BLS was 3.4%. If the deflater per BLS were used then GDP for 1stQ2011 would have been +0.56% annualized.

The fundamentals and the techs indicate lack of confidence in economic recovery. Fiscal policy (deficit spending) did not produce the desired results and monetary policy (expanded monetary base and low rates) had not gotten the economy going again. When we started the National Homeownership Strategy in 1994 no one imagined the size of this disaster.

Following are a couple of tables detailing GDP. These (and the intervening commentary) were created by Rick Davis of Consumer Metrics. The public part of what Rick produces may be found at http://www.consumerindexes.com/

GDP Components Table

	Total GDP	=	C	+	I	+	G	+	(X-M)
Annual $ (trillions)	$15.0	=	$10.7	+	$1.9	+	$3.0	+	$-0.6
% of GDP	100.0%	=	71.0%	+	12.5%	+	20.2%	+	-3.8%
Contribution to GDP Growth %	1.84%	=	1.53%	+	1.45%	+	-1.07%	+	-0.06%

The quarter-to-quarter changes in the contributions that various components make to the overall GDP can be best understood from the table below, which breaks out the component contributions in more detail and over time. In the table we have split the "C" component into goods and services, split the "I" component into fixed investment and inventories, separated exports from imports, and listed the quarters in columns with the most current to the left:

Quarterly Changes in % Contributions to GDP

	1Q-2011	4Q-2010	3Q-2010	2Q-2010	1Q-2010	4Q-2009	3Q-2009	2Q-2009	1Q-2009
Total GDP Growth	1.84%	3.11%	2.55%	1.72%	3.72%	5.02%	1.59%	-0.69%	-4.88%
Consumer Goods	0.83%	2.10%	0.94%	0.79%	1.29%	0.42%	1.62%	-0.32%	0.41%
Consumer Services	0.69%	0.70%	0.74%	0.75%	0.03%	0.27%	-0.21%	-0.79%	-0.75%
Fixed Investment	0.26%	0.80%	0.18%	2.06%	0.39%	-0.12%	0.12%	-1.26%	-5.71%
Inventories	1.19%	-3.42%	1.61%	0.82%	2.64%	2.83%	1.10%	-1.03%	-1.09%
Government	-1.07%	-0.34%	0.79%	0.80%	-0.32%	-0.28%	0.33%	1.24%	-0.61%
Exports	1.16%	1.06%	0.82%	1.08%	1.30%	2.56%	1.30%	-0.08%	-3.61%
Imports	-1.22%	2.21%	-2.53%	-4.58%	-1.61%	-0.66%	-2.67%	1.55%	6.48%

Monetary Regimes

Over the next month I will try to look at monetary policy. To start I am recycling this piece I wrote last July. Credit for anything insightful should go to economist Steve Hanke of Johns Hopkins University.

Money Supply and monetary policy are set by the Federal Reserve. While the Fed has the dual mandate of keeping unemployment and inflation low the effects of those decisions reach beyond our borders as dollars are created. Expansion of money supply threatens the dollar value on FOREX. Let's look at the three types of exchange rate regimes.

There are three types of exchange-rate regimes. An exchange-rate regime is the way a country manages its currency with respect to foreign currencies. It is a set of rules for how to determine money supply. It is important to understand that the type of money regime we have is our choice but once we have made that choice we are stuck with the benefits and risks of that regime.

The three regimes are: floating, fixed and pegged. Let's start with floating since that is what we have here in the U.S. Under a floating regime, the central bank (the Federal Reserve in the U.S.) sets monetary policy (size of the money supply and short-term interest rates) but has zero say over exchange rates. The dollar floats freely. The Fed is free to increase or decrease the money supply to (presumably) satisfy its dual mandate of low inflation and low unemployment paying less attention to the dollar value.

Under a fixed regime a currency board which has no power over money supply sets the exchange rates and monetary supply movement is determined by the the balance of payments. In a sense this is like the old gold standard where gold is replaced by foreign currencies. You increase your money supply when your foreign reserves increase and you decrease it when your foreign reserves decrease. There is also a type of fixed regime in which the currency is "dollarized" using a foreign currency as its own. This occurs in some Central American counties which use the U.S. dollar. Countries currently dollarized are Panama, Ecuador and Peru.

Both floating and fixed regimes have no conflict between monetary policy and exchange-rate policy. Market forces act so as to balance the flows of money and avert balance of payments crises.

The third regime is the one which is fraught with problems because it, unlike fixed and floating, has no inherent equilibrium system. This regime is called "pegged". One problem is that economists are not precise in their use of the term "pegged" often using "pegged" and "fixed" as interchangeable. Hanke points out that the essential difference is that with a pegged rate system economic policy seeks to serve two goals - exchange rate and monetary policy and that such a system is doomed. Pegged rate systems create conflicts between money supply and exchange rates because the monetary base is composed of both foreign and domestic components.

The discussion about what is in the best interests of the U.S. to "convince" China to do with its exchange rate misses the point. China should switch from its mega-awkward pegged system to a fixed system where it sets exchange rates and allows its monetary base to be determined solely by the foreign currencies deposited in its central bank. As longs as China maintains a pegged system the Chinese economy is at risk. Lacking the corrective equilibrium forces inherent in fixed and floating regimes a pegged regime will have its currency attacked by speculators who spot the inconsistencies between money policy and exchange rate. When that happened in Thailand consequent to the Asian Currency Crisis of 1997, the Suharto government which had been more than a bit repressive since it started in 1966 collapsed. In the words of that noted economist Cyndi Lauper - money changes everything.

 

---

Dick Lepre
RPM - SF
1400 Van Ness Avenue
San Francisco, CA 94109
DRE License # 01143973
NMLS Individual ID 302379
California Department of Real Estate - real estate broker license #01201643
dicklepre@rpm-mtg.com
Web site: www.loanmine.com
Blog: economy.typepad.com
(415) 244-9383
(866) 488-2051 fax

 

Rate Watch #776 The Economy. Mortgage Rates.

Rate Watch #776 The Economy. Mortgage Rates.

May 20, 2011
by Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com

The Technicals

Daily is bearish finally. Weekly is bullish. Monthly is bearish becoming neutral. The technicals are pointing to something most counterintuitive. Once the daily bearish cycle plays out we may see Treasury yield driven to the lows of last year. This is counterintuitive because it would coincide with the end of QEII and with the Fed no longer making purchases through POMO (Permanent Open Market Operations.) We have a market in which the biggest buyer has left the room, yet the techs are calling for higher prices and lower yields. Makes no sense. Right? The way in which this could play out are: 1) default on some Eurozone debt 2) the stopping of expansion of money supply will help pop the commodity bubble and the money being "invested" in commodities gets invested in Treasuries especially if GDP growth is slow casting concern about equities. But I am speculating. Let's see how this plays after the Fed exits POMO.

Jim Grauer (StoMaster) has a description as to how these techs can be used by mortgage professionals and borrowers. The detailed narrative may be found daily at StoMaster. Jim understands the techs as well as anyone whom you may see commenting in the media. He has been doing this for about 25 years and is capable of reading the technical patterns in the context of what they have indicated in the past. Most other technical analysis is much more simplistic.

Analysis

The techs are forecasting a bullish market for Treasuries in the next couple of months which may send Treasury yields and mortgage rates back down to the lows of last year. This is not a belief which is mainstream but it is what I see from the techs.

The Economy and Rates

I did not have time this week to write one of my lengthy discourses on the economy so let's just take a brief look at the signal from the techs because I find this most interesting.

Recent fundamental data show that economic growth has slowed. This is despite massive deficit spending and QEII. What we have seen recently with the bond techs is strong indication that investors are dubious that we are in a recovery which is anything other than meager. Also the dollar has regained strength popping the commodity bubble. It may becoming apparent that what the Fed has really supported is equities. Bernanke most definitely realized that there was value in pumping up equity prices because this generates a wealth effect making people feel better (and more disposed to spend) because they have regained some of the losses in their equity positions.

The monetary policy of the Fed, including paying banks interest for the excess reserves parked at the Fed has served to halt the interbank market and discourage lending. Add to that the constant barrage from politicians blaming banks for whatever and you have an economy slowed for lack of lending. Before it thinks of raising rates, perhaps the Fed should stop paying interest on excess reserves and allow the interbank market to return. The fed will have a much tougher time keeping short term rates on target if it allows those excess reserves to trade on the interbank market and "yes" that entails risks but the current zombie state of bank lending is unhealthy and deterring economic growth.

---

Dick Lepre
RPM - SF
1400 Van Ness Avenue
San Francisco, CA 94109
DRE License # 01143973
NMLS Individual ID 302379
California Department of Real Estate - real estate broker license #01201643
dicklepre@rpm-mtg.com
Web site: www.loanmine.com
Blog: economy.typepad.com
(415) 244-9383
(866) 488-2051 fax

 

Rate Watch #775 The Shadow Banking System

Rate Watch #775 Shadow Banking System

May 13, 2011
by Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com

The Shadow Banking System

If you want to give someone a good scare just say, "Shadow banking system." This expression was popularized by Bill McCulley of PIMCO in 2007. Before we talk about shadow banking let's first look at a traditional bank, what it does and what its risks are.

In a traditional bank depositors put money into accounts getting it back with interest and the bank loans out money to people and businesses charging them interest. If the bank is well run, its shareholders can share the profits. What are the risks? There are at least three:

1) the bank's liabilities are to the depositors. These are short term. Depositors can ask for their money back whenever they want. The banks assets are the loans it made. If the depositors, for whatever reason, all want their money back at the same time the bank cannot get the money back from the people it made loans to just because the depositors want their money. This is liquidity risk and this problem is solved by the Federal Reserve. It a bank needs cash, it can get it from the Federal Reserve by pledging some of those long-term assets. This discourages bank runs. In addition the FDIC insures the accounts of depositors so that they have no need to ask for their money if there is a rumor about the bank. Also the Basel banking accords require well-capitalized banks to keep reserves equal to 8% of their deposit liabilities.

2) the second risk is solvency. If too many of the banks loans go bad the bank will become insolvent having little or negative net worth. In this case the bank will be taken over by FDIC. Usually the liabilities (the checking and saving accounts) are sold to one bank and the assets (the loans) are sold to another. This almost always happens after close of business on a Friday so that, to a customer wanting to make a withdrawal, the effect is minimal. You go there on Monday and all you notice is that the name of the bank changed. The stockholders were wiped out but the depositors and anyone holding a check written by those depositors are protected. This last point about banks being the heart of our payment system is too easily glossed over.

3) the third type of risk is slower and less obvious. If banks make and hold fixed rate 30-year mortgage loans the interest rate on the asset side is locked in for years but the depositors will, if inflation picks up, move their money to a bank offering higher savings rates. The problem is that the durations of the bank's assets and liabilities are mismatched. Because interest rates can change substantially with time entities such as FNMA and FHLMC were created to buy mortgage loans from banks and sell them to investors who took the long tern rate risk.

Stop right here and realize that what is described above is the traditional banking system and the some of the regulatory structure which goes with it.

Let's Make Things Complicated

A large part of the shadow banking system consists of money market mutual funds. Money Market Mutual Funds, for the most part, take in money from investors who want interest rates higher than paid by commercial banks and S&Ls and lend money in the form of commercial paper to businesses and state and local governments. These are loans with terms less than 271 days. After the Lehman Brothers Bankruptcy on September 15, 2008 one money market mutual fund "broke the buck" meaning that its return to investors was negative. That week about $170 billion flowed out of money market funds as investors feared losses. Treasury announced guarantees to insure the depositors of these funds but there had been a mini-run on the shadow banking system. Having lost some of the confidence of its depositors, money market funds stopped buying commercial paper. This was disastrous to businesses and state and local governments and was not stabilized until the Fed announced the Commercial Paper Funding Facility to back commercial paper.

The fact that the commercial paper market seized was one of the most significant causes of the recession. Deprived of the ability to borrow, businesses had to downsize and we have not yet recovered from the effect.

The Rest of the Shadow banking system

In 1999 the Gramm–Leach–Bliley (GLB) Act was passed. The allowed for big banks to combine banking, securities and insurance companies under one corporate umbrella. The reasoning was that when times are good customers invest in equities and when time get tough they sell equities and keep their assets in cash (checking and savings accounts.) While some folks place the blame for the effects of the mortgage mess on GLB, I do not think that is accurate. Two points: 1) Wall Street was already well in control of non-GSE mortgage securitization long before that and 2) some of the big Wall Street investment banks did not merge with banks before the mortgage mess forced them to do so.

The problem with banks vis-à-vis the mortgage mess stemmed not from GLB but rather from something less apparent. The best explanation comes from the late economist Fisher Black. (Black was one of the creators of the Black–Scholes equation for calculating the correct price of derivatives. Since the Nobel Prize is not awarded posthumously Black did not share on the fruit of his work when Myron Scholes received the Nobel in 1995.) This paragraph is from the “Fundamentals of Liquidity” (1970):

"Thus a long term corporate bond [same is true for mortgages] could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the risk of default. The last two would not have to put up any capital for the bond, though they might have to post some sort of collateral."

Black was spot on long before this actually transpired. The buyers of Mortgage Backed Securities supply the money. Interest rate swaps bear the rate risk. Credit default swaps (CDS) bear the default risk. What happened was that commercial banks and investment banks joined forces to get both the rate risk and the default risk off the balance sheets of banks. Banks generated mortgages and sold all three parts - the money flow, the rate risk and the default risk to other entities. The risks were relocated from the banking sector to the shadow banking sector. To suggest that the shadow banking system was responsible here is only partially accurate. This was done with the knowledge and encouragement of banking regulators. Regulators wanted risk off the balance sheets of the banks they regulated and were not cognizant of the fact that the same risk would wind up in a less regulated segment of the shadow banking system. Risk was not eliminated but only relocated.

The problem with the mortgage mess/liquidity crisis was simply that too many bad mortgage loans were made. This inflated home prices by expanding the demand to people who would not be able to make the payments. The system for separating off rate and default risk while it did not create the demand for bad mortgages certainly made the process of generating them easier. The fault was with 1) HUD for mandating that FNMA and FHLMC do subprime 2) banking entities such as Countrywide which plunged headfirst into non-GSE subprime and 3) the debt rating firms for providing bogus ratings for the debt. More accurately perhaps was that the debt rating firms treated mortgage default risk as static paying too little attention to the fatal combination of diminished underwriting guidelines and the housing bubble.

The whole thing blew up only when it was apparent that one of the entities which provided the credit default swaps - AIG - had never hedged its positions. It sold CDS but never purchased them. It was not until the week of the Lehman Bankruptcy that Moody's announced that it was less confident that AIG could actually pay all of the CDSs which it was holding for mortgage debt. That meant that not only AIG was in trouble but that anyone who thought that AIG was going to deliver if the mortgages defaulted had to go out and buy a back-up policy just at a time when the cost was increasing dramatically. The Federal Reserve and the Treasury Department moved in to mitigate the damage created by the collapse of AIG.

The problem was not that there were CDSs but that AIG did not hedge its risk. AIG was the whale at the dice table with all its chips on "pass" when the economy rolled craps. Worse yet, that whale could not cover his markers.

Now that most large investment banks are part of bank holding companies and are part of the Federal Reserve system there is less shadow banking than there was before the liquidity crisis. Sizable entities comprising the shadow banking system are: hedge funds, monoline insurance companies (these provide credit insurance for municipal debt), and money market mutual funds. Significant parts of the shadow banking system such as structured investment vehicles disappeared.

---

Dick Lepre
RPM - SF
1400 Van Ness Avenue
San Francisco, CA 94109
DRE License # 01143973
NMLS Individual ID 302379
California Department of Real Estate - real estate broker license #01201643
dicklepre@rpm-mtg.com
Web site: www.loanmine.com
Blog: economy.typepad.com
(415) 244-9383
(866) 488-2051 fax

 

Rate Watch #774 Does the Economy Need Higher Interest Rates?

May 6, 2011
by Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com

Analysis

I started writing this piece early this week and after Thursday's commodity selloff and doubt about recovery the suggestion that the Fed needs to start increasing rates seemed inappropriate. The point of the following is that there is a perspective from which we need higher rather than lower Fed rates in order to grow. This cannot be done until there is greater confidence from business and consumers. What is discussed and suggested below must be implemented but not at present.

Fearing deflation, the Federal Reserve launched QEII. Now we have low rates, stagnant GDP, inflation (CPI-U) higher than GDP growth and the jobs market going nowhere. The deflation which never happened was to be avoided because deflation would cause investors to sit on their liquid assets. Still we have almost $1.5 trillion in excess banking reserves parked at the Fed which is, in effect, the one of the things they were trying to avoid. It may be time for the Fed to rethink what rate policy will lead to economic growth.

Elasticity of Supply & Demand

Interest rates are at rock bottom but yet there is not enough borrowing/lending. Such a situation is indicative of inelasticity of supply and demand. Let's look at supply, demand, and elasticity in general and then see how these pertain to money. Money has supply (created by the central bank), demand created by borrowers and restrained by federal and international banking regulations, and price (interest rate.)

Demand, Supply, and Elasticity.

"Demand" is the amount of stuff that consumers are willing and able to buy at a given price. Many folks would like a 6 bedroom home with a great kitchen, a pool, a wine cellar, and entertainment center with a 6 foot HDTV and a 6 car garage. The prices of such homes being what they are, few people are willing and able to buy at current prices.

"Utility" is the satisfaction people get from consuming (using) a good or a service. Utility varies from person to person. It varies by taste. It also varies by circumstances. Some people get more satisfaction from wine than others. Unless I am trying to impress someone, it is unlikely that I will spend $100 on a bottle of wine unless I can appreciate its value. The same person may get less satisfaction by drinking a bottle of Chateau Lafitte Rothschild once he is too drunk to distinguish it from Ripple.

The amount of a stuff demanded depends on:

- the price of the good
- the income of the would-be buyer
- whether the buyer likes it (consumer taste)
- the demand for alternative goods which could be used (substitutes)
- the demand for goods used at the same time (complements)

Complements are like pickles. If McDonalds sells fewer quarter-pounders the demand for pickles goes down. If people eat fewer hot dogs they will buy fewer hot dog buns. As an extreme, people are unlikely to buy hot dog buns for hamburgers (substitutes) even if the price of hot dog buns is halved. They may buy more hot dog buns if the price of hot dogs is halved. (And I don't want to hear any stories about how your mom made you eat your hot dog on a slice of Wonder Bread. Moms understand substitutes.)

Supply

Supply is the amount of a good producers are willing and able to sell at a given price. The amount of stuff supplied depends on:

- the market price of the good
- the cost of producing the good
- the supply of alternative goods the producer could make with the same raw materials, plants, equipment and labor force
- the supply of goods produced at the same time (joint supply)
- unexpected events (i.e. "disasters") that affect supply.

The Law of Supply & Demand

In 1776 Adam Smith in "The Wealth of Nations" explained the law of supply and demand as: "The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labor, and profit, which must be paid in order to bring it thither."

And Then What?

So the "law of supply and demand" tends to set a "natural price" for stuff. The problem is that none of us are ever happy with the way things are. Companies want to do more business and, thus, are willing to "diddle" with the price of things in order to seek a greater market share and (perhaps) greater profits.

Elasticity

The price elasticity of demand measures how much the quantity demanded responds to a change in price.

Elasticity can be defined numerically as the change in demand divided by the change in price. (Since demand goes up as price goes down this number is actually negative and elasticity is more correctly mathematically defined as the absolute value of this number.)

Elasticity greater than one means demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in price. When the elasticity equals zero, demand is perfectly inelastic. There’s no change in quantity demanded when there’s a change in price.

Supply also has elasticity. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by percentage change in price. It measures how much the quantity supplied responds to changes in the price.

By the differences in nature between supply and demand (by that I mean that demand can change in a very short period of time) the price elasticity of supply is usually larger in the long run than it is in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good, so the quantity supplied is not very responsive to price. Over longer periods, firms can build new factories or close old ones, so the quantity supplied is more responsive to price - in the long run.

One thing that we have seen lately is that some commodities, such as crude oil, have relatively inelastic supplies. The lack of supply elasticity translates into too small an increase in supply with rising price which has sent prices spiraling upwards.

For an economy to function well elasticity or inelasticity is not a neutral proposition. Elasticity is better than inelasticity because it allows a means to stimulate production, GDP, jobs, taxes when the economy is languishing. Elasticity is good; inelasticity is bad.

Money Also Has a Price - Its Name is Interest Rate

While these rules pertain to most all commodities, I want to note that they also pertain to our favorite commodity - money. Money has a price. The price is the interest rate. The discussion about supply, demand and elasticity pertain to money and interest rates as well as they do to oil, precious metals or agricultural commodities.

Interest elasticity of supply represents a change in the quantity of loanable funds supplied in response to a change in interest rates. Interest elasticity of demand represents a change in the quantity of loanable funds demanded in response to a change in interest rates.

Lurking behind interest elasticity is the willingness of banks to lend. They may, in fact, have a ton of loanable funds but are in fear of losing it to bad loans. Ultimately there is a loan to be made. The risk must be factored in and the borrower and lender strike a deal which they each feels to be beneficial to them. Tighter banking regulations (Basel II) discourage lending. Continued dissing of banks by politicians and the regulatory consequence of Dodd-Frank provide reasons for banks to not lend.

So What's Wrong?

Rate lowering alone does not lead to significant long-term economic growth. It merely helps to create an environment in which it can happen. Existing businesses and entrepreneurs will make investments and create jobs when the reward from those investments outweighs the risks.

The are other actions that the Fed might undertake to jump-start business activity. The problem may be in the yield curve itself. The Fed dictates the short end (the overnight rate) and, to the extent that the short end dictates Prime it also dictates the Prime rate. But this is still short-term money. In terms of our mortgage world, businesses that get Prime based loan are getting volatile ARMs If I am a businessman wanting to make a capital investment I would be much more interested in what I could borrow money for at a fixed rate for 10 or more years. This is the corporate bond market.

The "Liquidity Trap"

An extreme case of interest inelasticity could be a prelude the "liquidity trap." The expression "liquidity trap" is one of those things that economists like to argue about - as in "does it really exist?" Keynes used the expression to describe a situation where interest rates were so low that wealth holders chose to hold cash i.e. remain liquid rather than invest it or even put it in the bank.

The present situation is perhaps best described as "a zero interest rate trap." With interest rates so low, interbank lending may be stalled. Bank operate by making loan commitments and, if they do not have the cash they can borrow it on the interbank market now and increase savings rates to draw in deposits later. The interbank market may not be functioning because the reward (interest rate) is so low compared with the risk. Yes, the Federal Reserve acts as the lender of last resort and will always provide the cash needed but we may be seeing the effects of the interbank market still not functioning smoothly.

The implication is that the Fed keeping short term rates too low may be hurting rather than helping the economy. The most recent H.3 report from the Federal Reserve indicates that there are $1.474 trillion in excess banking reserves parked at the Fed doing nothing for the economy. The question is this: would higher rates help a good chunk of that $1.474 trillion to get out of bed and encourage GDP and job growth?

Since I am someone who thrives when interest rates are low this suggestion that we need higher interest rates is not in my interest but sometimes what is good for the economy and what is good for me are not the same.

It is also worth noting that Fed rates are so low that even a 2% increase in the Fed funds rate would still leave rates low.

---

Dick Lepre
RPM - SF
1400 Van Ness Avenue
San Francisco, CA 94109
DRE License # 01143973
NMLS Individual ID 302379
California Department of Real Estate - real estate broker license #01201643
dicklepre@rpm-mtg.com
Web site: www.loanmine.com
Blog: economy.typepad.com
(415) 244-9383
(866) 488-2051 fax