In short, just as no one really understood how
quantitative easing would work during the buildup,
no one knows how the unwind will play out.
Fourth, and closely related to the balance
sheet unwind, is how banks respond. Before the
financial crisis the ratio of bank loans to deposits
in the US was close to one for one – a relationship
that had persisted for decades.
Following the crisis, deposits resumed growing at near their
historical rate but lending languished. Today, the
ratio of loans to deposits is less than 80 per cent.
Most of those excess deposits are on deposit
with the Fed and funding the Fed’s bond
portfolio. What happens to those deposits as the
Fed’s bond portfolio runs off?
One possibility is banks invest in securities
that the Fed no longer owns. That essentially
would be a continuation of QE. A second option is
that nonbanks may buy the securities, and in the
process, withdraw bank deposits. Third, banks
could deploy those deposits as loans.
They don’t face the capital and regulatory constraints they
did earlier in the decade, and if economic growth
remains robust loan demand may rise.1 That in
turn could lead to economic growth and more
inflation, and present the Fed with the tough
choice of when to raise rates further.