Laughing all the way to the bank
Bank lending has held up despite rate hikes. Here’s why.
The Federal Reserve has raised interest rates at breakneck speed for the past year. Some economists and pundits expected people to borrow less in the face of these higher rates. But that didn't happen. In fact, bank lending has been strong. Across America, banks have issued new loans worth almost 5% of GDP in the past year. Bank lending has remained robust because the private sector's demand for loans is high. Incomes have risen, and asset prices have held up. Further, neither higher rates nor deposit withdrawals prevented banks from lending.
Most importantly, people have borrowed more because they're confident they can make repayments. Households and bosses feel this certainty because incomes and spending have risen. Over the past year, nominal aggregate demand, an estimate of total spending, rose 7%. Since a dollar spent is a dollar earned, incomes have risen. When incomes rise, interest payments become a smaller piece of earnings. That means people can borrow more again.
Contrary to common thought, rate hikes caused incomes and spending to rise. As the Fed pushed up rates, the government's interest bill, and deficit, went up. A wider deficit meant more money flowed into the economy. Since rates began to rise in March last year, the annual interest bill has increased by $310bn. Which, in turn, helped expand the deficit from 3.5% of GDP to 7%. That extra money sloshed around the private sector and stimulated demand.
People and companies borrow because they want to consume more than they earn and save. Credit cards let shoppers buy clothes now and pay for them later. Mortgages help families buy houses now and pay for them later. And business loans ensure bosses can buy machinery now and pay for it later. By bringing spending forward like this, the economy grows. Incomes rise, and productivity can improve.
Next, higher rates and fewer deposits don't limit bank lending. Banks have no problem lending when rates are rising. Similarly, they can still lend when deposits are leaving. Since they're profit-seeking, banks will lend whenever they can make money. Higher rates don't stop this. Banks will lend as long as they can charge an interest rate high enough to cover their costs and the risk. Regardless of where rates are—they could be zero, ten, or 50%—if a borrower can afford it, the bank will extend credit.
Banks also aren't limited by deposits, as they create money when they lend. When a customer gets a loan, the bank does two things: it credits the customer's deposit account, which is a liability to the bank, and records the loan as an asset. However, there are legal requirements for the amount of reserves the bank must hold at the central bank. So, after the bank makes the loan, they determine how many reserves they need. And if they don't have enough, they find them by borrowing them or selling assets to get them. Thus, the bank's ability to create new loans is not held back by their deposits.
Finally, asset prices haven't collapsed. The S&P 500 is up a quarter from its October lows, and house prices have stopped falling. In fact, according to Case-Shiller, a house price tracker, prices have risen recently. Pundits assumed that higher rates meant lower asset prices. But the relationship is more complex than that. Asset prices have supported bank lending because assets act as collateral. Households and firms can continue to borrow against the assets they have. That's doubly so when their values are rising. When asset prices rise, the private sector's net worth increases. Existing loans become a smaller proportion of asset values, and loan-to-value ratios drop. People then have more room to borrow more and more.
"A bank is a place that will lend you money if you can prove you don't need it." — Bob Hope.