Unintended consequences of "QE2"

By George Darling, Darling Consulting Group

One group praises the Fed for taking aggressive action. Another group questions whether lower interest rates will really stimulate economic growth or just create more problems for the economy in the future. 

One result of QE2 is not debatable—an extended term of QE2 has the potential of being a real problem for the community banking industry.

Fed action and the economy, thus far

There is no question that the Fed’s unprecedented purchase of mortgage-backed and government securities over the past two years has kept rates low and created an artificial market environment. Without Fed action, the yield curve would be much steeper and spreads would be much wider, as has been the case in past recessions. 

But, will continued low rates and tight spreads stimulate borrowing and growth? 

Have interest rate levels kept businesses from borrowing and expanding?

Have interest rates been too high to keep consumers from purchasing real estate?

Contrary to much political rhetoric and media coverage, most bankers are anxious to make loans to qualified borrowers. Conversations with lenders throughout the U.S. have had a recurring and similar theme: interest rate levels are not keeping small businesses from borrowing! 

The main reason for the lack of expansion and lethargic economic growth is the uncertain political climate in Washington, combined with an anti-business executive branch and an inhospitable regulatory environment. 

These conditions are making investors and small business owners rethink their investment and growth plans. The result: weak loan demand, slow economic growth, and weak job creation.

Aftermath of federal rescue

The Fed’s monetary policy, quantitative easing, and the economic stimulus package have flooded the market with liquidity and lowered interest rates to historic lows. However, the flattening of the yield curve associated with the precipitous drop of interest rates is causing gross profit margins (net interest income) in financial institutions to plummet. 

Asset yields are falling rapidly and can no longer be offset by lowering funding costs (as the rates paid for deposits approaches zero). Additionally, successful businesses that are accumulating cash, for which there is no return, are paying down debt rather than using cash for expansion. 

Many economists are expecting the current interest rate environment to extend far into the future—perhaps into 2015 or beyond. What this means for bankers is: limited growth opportunities—to go along with lower fee income and higher expenses associated with new regulations. 

A trio of ugly “solutions”

For many financial institutions, the only alternatives for survival will be: significant expense reductions and layoffs; increasing credit or interest rate risk beyond acceptable levels; or being merged or sold to another organization. 

The consolidation of the banking industry will accelerate to a point where there may be two to three thousand fewer financial institutions. This consolidation will mean fewer product offerings, reduced consumer services and convenience, and increased costs of credit.

Ultimately it will lead to higher unemployment throughout the United States.

Whether QE2 will help “jump start” the economy is very questionable unless it is accompanied by a change of attitude in Washington, D.C. The current level of interest rates and abundant liquidity in the financial system will not be a panacea. The solution to stabilizing the residential real estate market and generating economic growth in the U.S. is to put people back  to work. This cannot be done without eliminating the uncertainty that Washington has created relative to tax policies (reinstatement of the Bush-era tax cuts) and providing incentives for investment (e.g. investment tax credits) to create jobs and put America back to work.

In the interim, the Federal Reserve should rethink the impact of QE2 on financial institutions and allow capital markets to seek their own level across the yield curve. A steeper yield curve will mean healthier and more competitive financial institutions and more consumer options for the future. Allowing the capital markets to be free of Fed manipulation could also build more confidence in the economy, result in a more stable U.S. dollar and hopefully, cut inflation fears.

About the author

George Darling is CEO of Darling Consulting Group, Newburyport, Mass. Darling and the consultants of his asset-liability management firm write the bankingexchange.com "ALCO Beat" column. Darling’s professional experience includes: thirty years with his own company, two years as a senior executive with a $2 billion financial institution, two years with a Big Five Accounting firm, and ten years with IBM. He is a nationally-recognized resource for assisting financial institutions in the areas of interest rate risk management, liquidity management, and capital planning.