Bluffing

It’s one of those planted stories that you have to get used to when you live in a planned economy.  Which we do.  Our pretenses to “capitalism” notwithstanding.

The Chairman of the St. Louis Fed comes out with a prediction that interest rates will begin to rise early next year, much sooner than anyone else at the Fed has been predicting.

I don’t see how this is possible without destroying the banking system, because the banking system is already holding, as “assets”, so much low interest debt – mostly USG bonds – and rising interest rates will virtually wipe out the value of those assets.

Yet the perpetually low interest rate environment has unarguably depressed the economy, sort of the opposite of what it’s supposed to do but this is a common feature of modern economics:  upside-down results followed by lots of head scratching.

This may all be feigned, of course.  It seems to me that the (probably unconscious, or semi-conscious) purpose of the central bank is to prop up the banking system for the benefit of the financial and government sectors, even if it does depress the real economy.

So, you know, Japan

At the same time, one wonders if the Fed might just be able to pull it off.  We are, after all, in uncharted territory.  Japan doesn’t have the “world’s reserve currency” or, say, the world’s greatest nuclear arsenal.

I’m open to other ideas on all this.  Don’t seem to be many out there, though.

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4 responses to “Bluffing

  1. I don’t see how this is possible without destroying the banking system, because the banking system is already holding, as “assets”, so much low interest debt – mostly USG bonds – and rising interest rates will virtually wipe out the value of those assets.

    Treasury securities have accounted for between 3.6% and 4.1% of commercial banks’ assets in recent years. Changes in interest rates do affect bond prices but they are unlikely to ‘wipe out’ the value of the bond. Take a look here at how these bonds trade given considerable variation in the coupon.

    http://finra-markets.morningstar.com/BondCenter/Results.jsp

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    • Hello Art.

      Well. thanks for the correction.

      “Wipe out” was not a good choice of words. “Greatly diminish” would have been better. But the main point is still valid and, more to the point of why we’re writing about it here, under-appreciated.

      It doesn’t matter that much whether the low yield “assets” commercial banks hold are treasuries or other loans. The fact is that a rising interest rate environment will substantially reduce the value of those assets and affect the banks’ balance sheets accordingly.

      The other under-appreciated part of the dynamic here is the effect of interest rates starting to rise on potential new loans. A rising interest rate environment should, ironically, prompt borrowing and lending, if there is any demand there to tap. The reason is the incentives involved: in a declining interest rate environment there is an incentive to hold off borrowing because you can borrow cheaper later; in a rising interest rate environment of course the reverse is true, that is, there’s an incentive to borrow now because borrowing later will be more dear.

      So if you’re at the Fed here’s the gamble: if there’s demand out there to tap, the banks take a hit on assets but that can be offset by the ability to make new loans at higher rates. But if there’s no demand out there the higher rates will hit the banks and there won’t be any new loans to offset the hit.

      That’s one problem.

      The other problem is that new loans are the only path to increasing the money supply and address the ongoing specter of disinflation or even deflation.

      I don’t think the Fed is going to make the gamble because they know there’s no demand out there. That’s why I’m saying they are bluffing. Or maybe they’re just floating the trial balloon in an effort to get a better read on whether there’s demand.

      Anyway that’s my take. I find this stuff interesting.

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      • It affects their balance sheet if the accounting rules identify liquidity and solvency, which has been the complaint about mark-to-market accounting. The redemption value of the bond if you hold it to maturity is what it is. The market price is what you get for it now.

        As we speak, about 20% of commercial banks’ assets are in the form of securities; some portion of that consists of equities. Cash and reserves amount to another 20%. If I am not mistaken, a loan is marked at book value unless a loan is in default. About 40% of the loan portfolio is in the form of residential real-estate loans which are typically on the books for a year or two before being sold on the secondary market. Currently, bank capital amounts to 11% of assets.

        Interest rates go up and down. No need to be too anxious about this.

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        • Doesn’t Basell III require mark to market accounting? Maybe I’m misinformed on that.

          And isn’t “bank capital” …. government securities (bonds)?

          And isn’t currency a debt obligation of the Fed, not terribly different from a bond?

          Glad you’ve come by. Sounds like you know more about pracitcal banking than I do. I’ve been looking for someone like that to keep me grounded on these issues.

          I’m not anxious, BTW. Just trying to figure things out.

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