By Steven K. Beckner

(MNI) – One harsh reality which Federal Reserve policymakers face
as they try to sustain a modest recovery and reduce unemployment is that
the banking system, through which monetary policy works, is not playing
its normal role of channeling easier credit to the economy.

It is a problem of which Fed officials are abundantly aware. An
assortment of officials of different stripes have complained in recent
months that the “monetary transmission mechanism” is not working
properly because credit is not flowing through regular channels. So
monetary policy is less effective despite the unprecedentedly low
interest rates and high volume of reserves the Fed has provided.

“Because some creditworthy households are finding it difficult to
obtain mortgage credit or to refinance, the strong actions taken by the
Federal Reserve to put downward pressure on longer-term rates and to
improve financial conditions have had less effect on the housing sector
and overall economic activity than they otherwise would have had,” Fed
Chairman Ben Bernanke said.

San Francisco Federal Reserve Bank President John Williams said
“the monetary transmission mechanism is partially clogged” and
complained, “credit market frictions make refinancing and other housing
activity less responsive to changes in interest rates.”

Atlanta Fed President Dennis Lockhart observed “the transmission
mechanism of monetary policy is — choose your adjective — broken,
clogged, impaired.”

This clogging “means low rates aren’t stimulating much in the way
of credit growth,” said Lockhart. “It means some bankable loan demand is
not being met in spite of ample liquidity. And it means final demand for
goods and services remains subdued and the added employment that growing
final demand ought to generate is slow to materialize.”

But it’s a problem which policymakers feel somewhat helpless to do
a lot about. Indeed, some observers, as well as some officials
acknowledge that the Fed’s own banking regulations, mandated by
Congress, are part of the problem.

Bernanke, in an April 9 speech, said that, henceforth, financial
stability policy will “stand on an equal footing with monetary policy as
a critical responsibility” of the Fed and other central banks.

But some fear that efforts to guarantee financial stability and
avert another financial crisis have gotten the upper hand over monetary
policy.

The Fed has a wide-ranging mandate as the United States’ chief
financial regulator, under the 2010 Dodd-Frank Wall Street Reform and
Consumer Protection Act, to impose reforms aimed at correcting problems
that led to the financial crisis.

The Fed and its fellow regulators are in the process of increasing
capital requirements and liquidity buffers; imposing larger capital
cushions on the largest most “systemically important” banks; restricting
certain bank activities; issuing rules designed to protect consumers,
and promulgating numerous other regulations, as required by the
2,319-page law and by the Basel III international capital accord.

Under Basel III, starting next year, banks will have to phase in
higher capital standards. Their common equity ratios will go from 2% to
4.5% and their Tier I capital from 4% to 6%. The accord, reached by U.S.
and foreign regulators, also imposes additional capital buffers and a
minimum 3% leverage ratio.

The Fed has conducted stress tests to determine whether the largest
banks have sufficient capital to weather adverse economic and financial
scenarios. If not they must come up with more capital. Meanwhile, it has
been developing regulations to implement the innumerable sections of
Dodd-Frank — sometimes resulting in considerable resistance and
controversy, e.g. the so-called “Volcker Rule” restricting proprietary
trading.

While higher capital requirements are widely acknowledged to be a
good thing — indeed essential to the restoration of sound lending —
the process of implementing them is painfully slow, and in the meantime,
bank credit growth languishes.

To meet higher capital requirements, as well as to correct for past
excesses, banks have often curtailed their lending. Uncertainty about
the economic outlook, along with limited credit demand, have also
contributed to the lending restraint. As a result, there has been only
meager growth in the credit aggregates.

True, commercial and industrial loans grew by 9.9% last year after
contracting by 8.9% in 2010 and by 18.6% in 2009. C&I loans have
continued to rise so far this year, though at a diminished rate. They
were up an annualized 8.6% in March.

But total loans and leases, the credit aggregate that excludes bank
securities investments, continue to grow very slowly. After plunging for
two years, they were up in 2011, but only by 1.8%. Total loans and
leases grew just 1% at an annualized rate in March, as real estate and
home equity loans remained weak.

Consumer loans, which fell 0.7% last year, have picked up a bit
lately, but still grew just 3.6% in March, after two months of decline.

The anemic growth of credit helps keep money supply growth and in
turn inflation under control, because banks’ excess reserves built up
through quantitative easing are remaining largely immobilized. But the
inflation engine is idling at the cost of sluggish economic growth and
still-high unemployment.

Many members of the Fed’s policymaking Federal Open Market
Committee would undoubtedly prefer to have the problem of having to
combat excessive lending, money growth and wage-price pressures than
have to deal with a stalled credit motor.

Despite keeping the funds rate near zero for nearly 3 1/2 years and
buying more than $2 trillion of bonds to push long-term interest rates
to historic lows, economic growth has remained subpar, unemployment
remains at 8.2% and job gains have slowed.

Fed officials have been pulling their hair and asking, “Why?”

The answer they have come up with, in many instances, is that
monetary policy is butting heads with bank regulatory policy.

Harvey Rosenblum, director of research for the Federal Reserve Bank
of Dallas, blames Dodd-Frank in part for the sluggish bank lending that
is impeding the Fed’s low rate policy from translating into stronger
credit growth.

“The verdict on Dodd-Frank will depend on what the final rules look
like,” he wrote in the Dallas Fed’s recently released annual report. “So
far, the new law hasn’t helped revive the economy and may have
inadvertently undermined growth by adding to uncertainty about the
future.”

“A prolonged legislative process preceded the protracted
implementation period, with bureaucratic procedure trumping
decisiveness,” Rosenblum continued. “Neither banks nor financial markets
know what the new rules will be, and the lack of clarity is delaying
repair of the bank-lending and financial market parts of the monetary
policy engine.”

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