In this commentary I will explain the relationship between the shape of the yield curve, the behavior of nominal thin-air credit and the behavior of real aggregate demand for goods and services. Specifically, I will argue that there is a positive relationship between the “slope” of the yield curve and the percent change in thin-air credit. Further, I will argue that there is positive relationship between percent changes in real thin-air credit and percent change in real domestic aggregate demand for goods and services. For example, the steeper the slope in the yield curve, the faster will nominal thin-air credit grow. In turn, the faster will real domestic aggregate demand grow. The yield curve concept, I will be referring to is the spread between the yield on the Treasury 10-year security vs. the overnight federal funds rate (hereafter referred to as the yield spread). The importance of the federal funds rate in this yield spread will be explained later in this commentary. Thin-air credit for the purposes of this commentary will be defined as the sum of the asset categories of securities and loans on the books of depository institutions (currently, primarily commercial banks). “Thin-air” refers to the fact that the system of depository institutions has the unique ability among various other private lending entities to create credit figuratively out of thin air. (The central bank also has the ability to create credit out of thin-air. In fact, the central bank creates the “seed money” that enables the depository institution system to create thin-air credit.) The important implication of the ability to create credit out of thin-air is that the borrower can spend borrowed funds without necessitating any other entity to reduce its current spending. Thus, when new thin-air credit is created, we can assume that nominal current spending will increase, all else the same. (We cannot determine, a priori, what will be purchased by the borrowers of this new thin-air credit. It could be newly-produced goods and services or it could be existing assets, physical or financial.) We cannot make this same assumption when new credit is extended by non-depository entities. For example, if an individual extends credit, in order to fund that loan, she either has to cut back on her current spending or run down her current deposit holdings. If she reduces her current spending, i.e., increases her saving, no new net spending will occur from this loan because she will merely be transferring her spending ability to the borrower. If she funds the loan by running down her deposits, then there will be some net new spending in the economy. In economist jargon, this would be an example of an increase in the velocity of money. An increase in the velocity of money is another way of stating that there has been a decrease in the public’s demand for money balances. I am not aware of any statistic that measures total transactions in the US economy, transactions that include not only expenditures for newly-produced goods and services but also purchases of existing assets. So, I must rely on expenditures recorded in the National Income and Product Accounts (where the GDP data are reported). Because the bulk of thin-air credit created by US depository institutions goes to domestic borrowers, I have chosen Gross Domestic Purchases as my measure of aggregate domestic demand.
If you intend to read further, I would advise you have some Red Bulls on ice. It’s going to be a long one. Plotted in Chart 1 are quarterly averages of the level of federal funds rate (the blue line) and the yield spread between the Treasury 10-year security and the federal funds rate (the red bars). The gray shaded areas demarcate periods of recession. Notice as the federal funds rate declines, the spread tends to widen. Similarly, as the federal funds rate rises, the spread tends to narrow, sometimes going into negative territory. Why might this be, especially, why might the spread narrow when the federal funds rate rises? Remember, the Federal Reserve sets the level of federal funds rate. It does so by regulating the supply of cash reserves it creates out of thin-air in relation to the amount of these reserves demanded collectively by depository institutions (hereafter, banks). Prior to March 26, 2020, the Fed imposed reserve requirements on banks. That is, banks were required to hold as cash reserves (either on deposit at the Fed or as coin/currency in their vaults) in an amount equal to a specified percentage of their deposits. The Fed varied this percentage from time to time for reasons known only to the Fed. Prior to October 9, 2008, when the Fed began paying interest on reserves held by banks, these required reserves largely defined banks’ demand for reserves. If the Fed wanted to increase the level of the federal funds rate, it would reduce the amount of reserves it supplied relative to banks’ demand for reserves. Even if the Fed had not imposed reserve requirements on banks, they still would have had a demand for reserves. Banks would want to maintain a certain level of reserves to cover their clearings with other banks. As mentioned above, on October 9, 2008, the Fed began paying interest to banks on their reserves holdings. The reason it did so was to increase banks’ demand for reserves. In November 2008, the Fed began its first round of quantitative easing (QE), which added reserves to the banking system, but had not yet lowered its federal funds target to zero. In order to prevent the federal funds rate from falling to zero, the Fed induced the banking system to hold these extra reserves by paying them interest on their reserves holdings. Eventually, the Fed lowered its target for the federal funds rate to zero, yet the Fed continued to pay interest on reserves held by banks’ as it still does to this day. Why?
