One of the brightest spots on the economic horizon is the steady rise of total bank credit over the past six months. It’s an important indicator that is often overlooked. Between March and September of this year bank credit has increased by nearly 12% at an annual rate. Over time bank credit correlates reasonably well with nominal GDP — meaning this economy is poised to get into gear.
This is a demand-side monetary model (the supply-side of the economy is more affected by after-tax returns to work, saving, investment, and risk), and it goes like this: The Fed issues high-powered credit to the banking system as payment for the purchase of Treasury securities from primary dealers. Banks then use additional Fed-credit resources either to invest in Treasury securities bought from primary dealers or to make loans to businesses and consumers. Ultimately, bank loans or investments pump credit into the economy.
In other words, the Fed injects credit into the financial system, and then the banks inject credit into the economy. Of course, the operation can work in reverse. If the Fed starts withdrawing credit by selling Treasury securities, this reduction of bank resources will force financial institutions to liquidate loans or sell investment holdings. As you might guess, all this has a big impact on total spending and investing in the economy as measured by changes in nominal gross domestic product.
By this logic the recent expansion in bank credit is a welcome economic development. Over the past year the central bank has expanded its own balance sheet by 8.5%. During that time the aggregate balance sheet for all commercial banks in the U.S. has expanded by almost 6%. Over the past three- and six-month periods, total bank footings have grown by nearly 12%, a very positive trend for future economic expansion.
In this new environment of built-up liquidity supplied by the Fed, banks are probably willing to make business loans. Yet business-loan demand is virtually nil, as both corporate and small-business credit quality still suffers in the aftermath of a deflationary recession. The recent rise in bank credit is mainly a result of investments in Treasuries, currently at a 22% annual rate. Commercial and industrial loans to businesses are still shrinking at a near 10% pace. There is some lending activity, however. Bank mortgage loans are rising at a 12% rate, spurred on by a remarkable interest-rate decline. But overall lending operations, critical to solving the corporate credit crunch, are not nearly as robust as they need to be to help along this recovery.
Business investment in capital goods has been flat most of this year, after a vicious decline from the middle of 2000 to the end of 2001. Over the past twelve months orders and shipments for non-defense capital goods (excluding aircraft) are rising by only 1% to 2%. Inventories have turned up slightly, but the evidence suggests that firms prefer to finance production out of their current cash flows.
Overall economic activity in the third quarter, a number that comes out this week, could rise by about 3.5% at an annual rate, once again led by consumer spending. Business investment will rise slightly, as will the level of inventories. If this is the case, it will mark the fourth recovery quarter of growth, amounting to a 3.1% rate of rise. So, from the bottom of the recession that ended a year ago, real GDP will have increased $287 billion. From the peak of the last boom, which is marked at the end of 2000, real GDP will have gained $230 billion.
If accommodative Federal Reserve policies continue to fill the economy with liquidity, and if the decline of individual and business tax rates is left alone, then economic and stock-market recovery will continue, however gradually. To be sure, the most disappointing part of the economic scene is the stock market. Until very recently, the market has been discounting a continual recession scenario. But market sentiment is now improving a bit, and the major averages are beginning to respond to a rise in corporate profits.
Still, it remains absolutely essential that the Federal Reserve be as generous as possible in pumping credit into the banking system. The central bank should make sure to accommodate the rise in economic demands for money by pouring plenty of high-powered cash into the economic pipeline, which begins with the banks. And as an insurance policy, there’s no reason why the Fed shouldn’t reduce its federal funds interest-rate target by a good 50 basis points on November 6, the scene of its next meeting, one day after the mid-term elections. Such a cut will make certain there is a sufficient liquidity base to fuel business expansion.
If the Republicans sweep the Senate and the House, tax-rates will be cut even more and the supply-side of the economy will expand more. Hopefully demand-side monetary policy will accommodate new supply-side incentives by filling up the proverbial economic bathtub with liquidity that rises right to the rim.