Viewpoint: Why the world needs supply-side monetary policy

The world needs supply-side monetary policy. Thanks to the US Federal Reserve, it gets demand-side. But what is the difference and why is it important?

It's all about the eagerness of lenders to lend versus the eagerness of borrowers to borrow. Demand-side policy tinkers with interest rates to influence demand for bank loans. Supply-side influences the supply.

For five years, central banks have pushed demand-side monetary policy-lowering rates to make people borrow. It hasn't worked. Why? Because it makes banks less eager to lend. We need supply-side monetary policy to fix this.

Pretend you're a banker. Your core business is borrowing from depositors at short-term rates, lending at long-term rates and living off the spread.

A bigger gap means bigger potential future profits and makes you want to lend more. If the spread grows from 1% to 2% or even 3%, extending loans generates you much more profit and you'll lend more eagerly.

Supply-side monetary policy would let long-term rates rise so the yield spread could widen. For the US, this means ending quantitative easing (QE).

With QE, the Federal Reserve lowered long-term rates thinking this would make borrowers more eager. But it actually shrank the yield spread, cutting loan supply!

Rate shifts impact supply much more than demand. Hence supply-side monetary policy is more powerful than demand-side. Supply-side is what the Fed always did before 2008; demand-side since.

Put your banker's hat back on. Imagine long and short rates were both fixed at zero. You as a banker would never lend a cent. You'd never take risk for no profit. Boneheaded business.

Now, pretend you're a potential borrower - chairman of the board at a moderately big, publicly-traded firm. I'm the chief executive who reports to you. Our price/earnings (P/E) ratio is 14 and our earnings yield - the P/E's inverse - is 7%. We have an investment-grade credit rating, so we can borrow long-term money at 5%, 3% post tax.

Business plan

Imagine I ask you to approve a new long-term business plan. The expected return matches our earnings yield, 7%. Does it matter to you, chairman, if our borrowing costs go from 3% to 3.5%? Even 4%? No!

Even with the higher rates, your profit margin is big. Your eagerness to borrow isn't hurt much by the small cost increase. If the small hike made the deal look bad, it probably wasn't worth doing at all.

Demand-side monetary policy ignores this, which is the key flaw. The Fed thinks reducing borrowing costs creates an incentive to borrow. Maybe so, but marginally higher rates don't reduce that incentive much for good projects. They don't pinch profits enough.

For bankers, though, even a small profit boost means much more lending. Profit is compensation for risk taken - so the higher the potential profit, the more risk a bank is willing to take.

Six months ago, when Britain's rate spread was 1.19%, banks would consider only the most creditworthy borrowers as it wasn't worth their while to branch out.

Today, the rate spread is 2.17% - remember risk brings bigger payouts. Banks can lend to a much bigger pool. All the small businesses and entrepreneurs shut out when spreads were 1.19% can finally get money.

This is great for growth. When small businesses and entrepreneurs can borrow more, they can spend more on research and development, lease new facilities, buy new software and equipment, buy more raw materials to boost output, and hire more. This helps these firms grow and moves more money through the real economy. The more firms qualify for loans, the more this happens - when rate spreads are flat, it doesn't.

You know this already - you lived the UK QE nightmare for over four years. You saw Britain's yield spread shrink, bank lending fall, M4 money supply reel, actually shrink, and GDP sag.

After QE, you saw life get better. The rate spread widened, lending stabilised, M4 rose and then faster and GDP accelerated. GDP hit a three-year-high 0.8% quarter-on-quarter in the third quarter. Your Leading Economic Index says growth will continue, propelled by a wider rate spread.

When the Fed finally ends QE, the US rate spread will widen, boosting loan supply and fueling faster growth.

Long-term rates in developed and developing countries are highly correlated, so rate spreads will widen globally - get ready for a worldwide reacceleration party. With faster growth comes new opportunities for more cyclical stocks - stocks like the ones below.

Commodities

I'm not overly keen on energy now. Future pricing and cost pressures should impede earnings. But that's widely known and in current pricing.

Yet, it's hard not to love Royal Dutch Shell. At $215 billion in market cap it's neck and neck with PetroChina as third biggest. It's also well run and compellingly cheap - the cheapest of the biggies - at 40% of annual revenue, nine times my 2013 earnings estimate, with a 5.3% dividend yield.

The May merger of Xstrata into Glencore Xstrata created one of the world's largest vertically integrated non-ferrous materials firms. This stock will work its way into conventional portfolios everywhere eventually - think of it as a mix of commodities giants Rio Tinto and BHP Billiton. The Glencore part, largely focused on marketing and commodity trading, is volatile, but it has bounced some and will rise further still. The best way.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.