Which of the following fed actions will increase bank lending? This is going to be one of the most straightforward blog posts we have written in a long time. The truth is, all eyes have been and will continue to be on the Fed as long as they are the ones who have control over the money supply of the US.
Again, this is going to be a simple one today. We are looking to answer the question “which of the following fed actions will increase bank lending?” For this, we are going to look at two possible actions the Fed can take according to Quora:
- Lower interest rates translate to more money available for borrowing, making consumers spend more. The more consumers spend, the more the economy grows, resulting in a surge in demand for commodities, while there’s no change in supply. An increase in demand which can’t be met by supply results in inflation.
- Higher interest rates make people cautious and encourage them to save more and borrow less. As a result, the amount of money circulating in the market reduces. Less money, of course, would mean that consumers find it more difficult to buy goods and services. The demand is less than the supply, the hike in prices stabilize, and sometimes, prices even come down.
That’s it. We are going to decide between raising interest rates and lowering interest rates as a means to increase bank lending.
Higher Interest Rates
To see if raising interest rates will increase interbank lending, let’s use the example of Apple. We all know this company, it is the largest company in the world (currently with over an 800 BILLION DOLLAR market cap). While they are seen as the best company in the world due to them having the largest market cap, they too borrow money from the big banks. Let’s see how it might work for them. For this, we will use the example of the Fed Funds Rate being 0.75%, the banks (like JPMorgan) make money on any loan over 0.75%, and the Apple dividend currently at 2%.
JPMorgan goes to the Fed and says “Okay, we want to borrow 50 billion dollars from you.” The Fed turns around and says “Okay, that is going to cost you an interest rate of 0.75%.” JPMorgan does the deal.
Apple comes in and goes, “Hey JPMorgan, we want to borrow 50 billion dollars from you, what is the rate of interest you might charge me?
JPMorgan responds, “We will charge you 1.5%.” They do this because they know their margins are 0.75% on every loan they put out. They borrow for 0.75% and then charge another 0.75% on top of that to break even. Apple turns to them and goes, “Great, let’s do the deal!”
Apple can do this because they have a dividend of 2%. They are getting charged 1.5% on that money from JPMorgan but since they pay out a 2% dividend, they are making .50% on that money out of thin air.
This is a standard deal that has been happening for a very long time as long as the opportunity presented itself.
But what if the Fed decided to come in and raise interest rates to say 2%. Here is how the transaction would work.
Apple would call JPMorgan and say, “Hey, we want to borrow another 50 billion from you again, what’s the interest rate now?” JPMorgan goes to the Fed (knowing that they make a 0.75% margin on all of the money they lend out) and says “Hey guys, we want to borrow 50 billion again, what is the rate of interest we have to pay?” The Fed responds by saying, “2%”.
JPMorgan calls back Apple and says, “Hey Apple, we can do the deal for 2.75%.” The reason that is the interest rate is because the Fed is charging 2% and the bank needs to charge at least 0.75% to make any money on the deal.
Apple turns to them and says, “Nope, sorry. We can do the deal unless our rate of interest is under 2%.”
In this scenario, which is a real scenario, the answer is there would be no deal as JPMorgan would have to take a loss on this 50 billion dollar loan. Ain’t gonna happen.
Lower Interest Rates
We will use a similar example as the one used above. Again, the Fed has an interest rate of 0.75%, the banks need to make 0.75% on top of what the Fed rate is the make money, and Apple has a 2% dividend.
Apple calls JPMorgan and goes, “Hey JP, I want to borrow 50 billion, what are you going to charge me?” JPMorgan calls the Fed and goes, “Hey Fed, what can I borrow money from you guys at?” The Fed responds by saying, “Hey JP, we have just lowered interest rates of 0.25%, so you may borrow that 50 billion for 0.25%.”
JPMorgan almost trips over itself calling Apple and says, “Hey Apple, we can charge you 1% on that money.” Apple, being as savvy as it is, says to JPM, “Um, let’s make it 100 billion.”
Which of the Following Fed Actions Will Increase Bank Lending?
The above two example are real world examples. Companies will borrow almost unlimited amounts of money as long as they can profit from it. In the both of these scenarios, Apple is looking to borrow money at any rate under 2%. They have a 2% dividend and borrowing money at any interest rate under 2% is a very profitable proposition for them.
To answer the question “which of the following fed actions will increase bank lending?”, we looked at two scenarios.
- Raising interest rates
- Lowering interest rates
In scenario one with raising interest rates, we saw Apple have a ceiling for what interest rate they could borrow at. They turned down the deal once the rate of interest exceeded 2%.
On the other hand, when the rate of interest was far below 2%, they borrowed every single penny they could get their hands on. And when this happens, it significantly increases bank lending.
Apple is not the only company that does this trick. Every company does. This is how we have been able to have a historic bull market since 2009.
Any company in the world, I repeat any company in the world, will borrow crazy amounts of money as long as they can profit from it. This phenomenon can be seen during times of low-interest rates.
On the other hand, no company in the world will borrow money if it is not a profitable trade. This phenomenon can be seen during times of high-interest rates.
Question: which of the following fed actions will increase bank lending?
Answer: lower interest rates.