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Rising Mortgage Origination Hints at M2 Turn
One of the successes the Federal Reserve can tout from the last couple of years (and the list of them is pretty short, to be fair) is that after the unprecedented policy actions during COVID caused never-before-seen rates of money supply expansion, subsequent policy avoided normalizing that explosion.
Year over year growth in M2 reached 26.9%. But in 2022, as the Fed started hiking rates and shrinking its balance sheet, the rate of growth slowed until M2 reached its absolute peak in July 2022 and began to slowly decline. As of today’s H6 release, year-over-year M2 has been negative for 13 months in a row.
To be sure, after a massive explosion the level of M2 has not declined all that far as the chart below shows. I also documented this fact back in November in “Where Inflation Stands in the Cycle,” which was really a good piece. You should read it.
So the success of the Fed here can be summarized by saying, ‘at least they didn’t keep blowing up the money supply.’ Since the rise in prices is clearly and closely related to the explosion in the quantity of money we have seen (anyone who still resists this obvious truism after the mountain of recent evidence is added to the prior mountain of evidence), this was a sine qua non for getting inflation back down. It isn’t sufficient, unless it’s continued for a very long time, but it’s necessary. As I illustrated in that article linked to above (which, really, you should read), there are several ways that inflation could evolve from here as the shock to the system gradually unwinds. I’ve talked before about how velocity in the policy crisis behaved as a spring or a capacitor, absorbing a lot of ‘monetary energy’ that is doomed to be released back into the system. Velocity is still rebounding (in Q4, if forecasts for Thursday’s Advance GDP report are accurate, it will rise something like 4% annualized), but if money growth remains negative then that’s really the least-painful way this can resolve. In the last chart from that prior article (have I mentioned it’s worth reading?), slack money growth with decent growth and rebounding velocity is reflected in a movement mostly to the left, with the price level not rising much. Good outcome.
However, that outcome is predicated on the notion that the money supply remains slack. If M2 starts to rise again, then the curve drifts upward and the potential set of outcomes almost certainly involve higher prices. Naturally, I’m mentioning this because of developments that make me concerned on this score.
One thing that I seriously missed in 2022 was the fact that the increase in interest rates helped bring down money supply growth. That’s not at all intuitive, because in general changing the price of a loan tends not to change the demand for a loan by very much – especially when higher inflation is making the spot real interest rate paid by the borrower lower and lower. In other words, I assert with some decent evidence that consumer and industrial loan demand is somewhat inelastic for modest changes in interest rates. Ergo, my belief was that merely raising interest rates would not necessarily cause money growth to decelerate. As it happened, I was saved from my own mistake by the fact that the Fed was also shrinking the balance sheet, which (despite the fact that reserve balances aren’t binding on banks in the current environment, so they are essentially unconstrained in lending) I thought might help money growth to decelerate. Not that I thought we’d keep getting 20% growth, but I didn’t think we would have naturally seen money growth fall below, say, 5%. Fortunately, because the Fed was also shrinking the balance sheet my forecasts were not drastically inaccurate despite being wrongly inspired, and so I forecast 5.1% median inflation for 2023 and we got 5.06%. It’s nice when the ball actually bounces your way.
As it happens, though, for the most part higher interest rates seem to have not affected loan growth very much. C&I loan growth remained strong throughout 2022 and didn’t start to level off until the Fed was just about through tightening, and consumer loans as I expected really only started to level off when the Unemployment Rate started to rise…credit cards, not at all. And that’s because, as I said, most borrowers are not borrowing because they made a NPV calculation that said borrowing makes sense; they’re borrowing because they need to and 1% or 2% or 3% doesn’t really change that calculus very much.
But you know where it did change the calculus a lot? In mortgages. And that’s because a buyer might be reluctant to pay 1% more on a mortgage, but what the buyer also needs is someone who is willing to abandon their awesome loan. As has been noted elsewhere by lots of people, home sales absolutely cratered not because people weren’t wanting to buy but because there weren’t enough people who wanted to sell. So mortgage origination volumes also dried up, as a direct consequence of higher rates. The one large market where interest rates did have a big impact, although not for the reason you’d think, was in mortgages!
You know I wouldn’t say this unless I had a neat chart to show you. Here is the Mortgage Bankers’ Association Purchase index, tracking the volume of new loans for purchasing a home (in black), set against y/y money supply growth, in blue.
Let’s tie this up with a bow:
- Higher rates didn’t affect every kind of loan, but had a big impact on turnover, and thus origination, in one very large loan market: mortgages.
- Lower mortgage origination turns out to have been uncannily correlated with money supply growth. This may or may not be causal, but it at least means that mortgage origination merits consideration as a leading indicator of money supply growth.
- As interest rates have leveled off and even declined some, the housing market is gradually adjusting. We are seeing higher home prices, and mortgage origination has been showing signs of recovering as the chart shows (mortgage origination numbers are released before sales numbers, so expect a rise in home sales coming).
- It is going to be difficult for the Fed to keep the money supply shrinking, if origination of new mortgages rises even a little bit. This doesn’t mean M2 is going to skyrocket, just that it is going to stop shrinking (in fact, it has risen each of the last two months).
- If M2 rises at even a sober 5% pace, combined with money velocity that still has some normalization left, it will be extremely difficult for the Fed to hit its inflation target on a sustainable basis for some time.
And what should you do about it, just in case? For starters, read “Inflation Sherpa.”
The Monetary Policy Revolution in Three Charts
Over the last few years, I’ve pointed out exhaustively how the current operating approach at the Fed towards monetary policy is distinctly different from past tightening cycles. In fact, it is basically a humongous experiment, and if the Fed succeeds in bringing inflation gently back down to target it will be either a monumental accomplishment or, more likely, monumentally lucky. My goal in this blog post is to explain the difference, and illustrate the challenge, in just a few straightforward charts. There are doubtless other people who have a far more complex way of illustrating this, but these charts capture the essence of the dynamic.
Let me start first with the basic ‘free market’ interest rate chart. Here, I am showing the quantity of bank lending on the x-axis, and the ‘price’ of the loan – the interest rate – on the y-axis. If we assume for the moment that inflation is stable (don’t worry, the fact that it isn’t will come into play later) then whether the y-axis is in nominal or real terms is irrelevant. So we have a basic supply and demand chart. Demand for loans slopes downward: as the interest rate declines, borrowers want to borrow more. The supply curve slopes upward: banks want to lend more money as the interest rate increases.
An important realization here is that the supply curve at some point turns vertical. There is some quantity of loans, more than which banks cannot lend. There are two main limits on the quantity of bank lending: the quantity of reserves, since a bank needs to hold reserves against its lending, and the amount of capital. These are both particular to a bank and to the banking sector as a whole, especially reserves because they are easily traded. Anyway, once aggregate lending is high enough that there are no more reserves available for a bank to acquire to support the lending, then the bank (and banks in aggregate) cannot lend any more at any interest rate – at least, in principle, and ignoring the non-bank lenders / loan sharks. We’re talking about the Fed’s actions here and the Fed does not directly control the leverage available to loan sharks.
Now, traditionally when the Fed tightened policy, it did so by reducing the aggregate quantity of reserves in the system. This had the effect of making the supply curve go vertical further to the left than it had. In this chart, the tightening shows as a movement from S to S’. Note that the equilibrium point involves fewer total loans (we moved left on the x axis), which is the intent of the policy: reduce the supply of money (or, in the dynamic case, its growth) by restraining reserves. Purely as a byproduct, and not very important at that, the interest rate rises. How much it rises depends on the shape of the demand curve – how elastic demand for loans is.
As an aside, we are assuming here that the secondary constraint – bank capital – is not binding. That is, if reserves were plentiful, the S curve would go vertical much farther to the right. In the Global Financial Crisis, that is part of what happened and was the reason that vastly increase reserves did not lead to massive inflation, nor to a powerful recovery: banks were capital-constrained, so that the Fed’s addition of more reserves did not help. Banks were lending all that they could, given their capital.
Manipulating the aggregate quantity of reserves was the way the Fed used to conduct monetary policy. No longer. Now, the Fed merely moves interest rates. Let’s see what effect that would have. Let’s assume for now that the interest rate is a hard floor, and that banks cannot lend at less than the floor rate. This isn’t true, but for ease of illustration. If the Fed institutes a higher floor on interest rates then what happens to the quantity of loans?
This looks like we have achieved the same result, more simply! We merely define the quantity of loans we want, pick the interest rate that will generate the demand for those loans, and voila, we can add as many reserves as we want and still get the loan production we need. The arrows in this third chart show the same movements as the arrows in the prior chart. The quantity of loans is really determined entirely by the demand curve – at the prescribed interest rate, there is a demand for “X” loans, and since banks are not reserve-constrained they are able to supply those loans.
However, it’s really important to notice a few things. The prior statement is true if and only if we know what the demand curve looks like, and if the floor is enforced. Then, a given interest rate maps perfectly into Q. But:
- D is not known with precision. And it moves. What is more, it moves for reasons that have nothing to do with interest rates: for example, general expectations about business opportunities or the availability of work.
- Moreover, D is really mapped against real rates, while the Fed is setting nominal rates. So, for a given level of a nominal floor, in real space it bucks up and down based on the expected inflation rate.
- Also, the floor is not a hard floor. At any given interest rate where the floor would be binding, the desire of banks to lend (the location of the S curve) exceeds the demand for loans (by the amount of the ?? segment in the chart above). The short-term interest rate still affects the cost to banks of that lending, but we would still expect competition among lenders. This should manifest in more aggressive lending practices – tighter credit spreads, for example, or non-rate competition such as looser documentary requirements.
In the second chart I showed, the Fed directly controlled the quantity of reserves and therefore loans. So these little problems didn’t manifest.
Now, there is one advantage to setting interest rates rather than setting the available quantity of reserves as a way of reducing lending activity. Only the banking sector is reserve-constrained. If there is an adequate non-bank lending network, then the setting of interest rates to control the demand for loans will affect the non-bank lenders as well while reserve constraint would not. So this is somewhat “fairer” for banks. But this only means that non-bank lenders will also be competing to fill the reduced demand for loans, and the non-bank lending sector is less-vigorously regulated than the banking sector. More-aggressive lending practices from unregulated lenders is not, it seems to me, something we should be encouraging but what do I know? The banks aren’t lobbying me to help level the playing field against the unregulated.
Hopefully this helps illuminate what I have been saying. I think the final chart above would be a lovely final exam question for an economics class, but a bad way to run a central bank. Reality is not so easily charted.
