Sunday, September 7, 2014

The Seeds of U.S. Inflation Have Sprouted and Could Be in Full Flower in 2016

September 8, 2014

The Seeds of U.S. Inflation Have Sprouted and Could Be in Full Flower in 2016

I subscribe to the tenet espoused by the late Professor Milton Friedman that inflation is a monetary phenomenon. When I speak of inflation, I include not only the behavior of prices of goods and services but also the behavior of the prices of assets. I believe that a sustained acceleration in the growth of credit created figuratively out of thin air, i.e., the sum of credit created by depository institutions (e.g., commercial banks) in a fractional reserve monetary regime and credit created by the central bank, ultimately will result in the acceleration of prices of goods/ services and/or assets. Chart 1 shows that a sustained acceleration in thin-air credit has commenced. As of July 2014, the latest complete monthly data available, the year-over-year change in the sum of commercial bank adjusted loans, leases, securities (let’s call this bank credit) and commercial bank cash assets (let’s call this Fed credit, which will be explained below) was 9.7%, the fastest growth in this measure since December 2005. Starting in October 2013, year-over-year growth in this thin-air credit measure has consistently been above 8.0% vs. a 41-year median growth rate of 6.9%. Commercial bank cash assets largely are reserve balances held at the Federal Reserve as well as currency held as bank vault cash, both of which are Federal Reserve liabilities or credit created by the Fed figuratively out of thin air. (Commercial bank assets are adjusted for mergers and acquisitions with nonbank depository institutions such as S&Ls).
Chart 1

Also shown in Chart 1 are monthly year-over-year percent changes in commercial bank adjusted holdings of loans, leases and securities, with cash assets excluded. Notice that prior to 2009, the year-over-year percent changes in the two series in Chart 1 moved in close tandem with numerical values also very close, suggesting that the behavior of bank credit dominated the behavior of the sum of bank credit and Fed credit. With the onset of the financial crisis in late 2008, credit created by commercial banks, i.e., loans, leases and securities, contracted. With the extraordinary extension of Fed credit through the discount window and other facilities and the implementation of Fed outright securities purchases (QEI), a large increase in cash assets at commercial banks partially offset the declines in bank credit, keeping the year-over-year changes in the sum of bank credit and Fed credit positive through September 2009, albeit at a diminishing rate of growth.  From October 2009 until early 2011, the year-over-year changes in the sum of bank credit and Fed credit were consistently negative as Fed discount window loans were repaid, QEI was gradually terminated and bank credit continued to contract.

QEIII was initiated in the fourth quarter of 2012 as year-over-year growth in bank credit was slowing. Early in 2014, the Fed began its tapering its QEIII securities purchases. At the same time, year-over-year growth in bank credit picked up and has continued to do so throughout 2014. So, despite the slowdown in growth of Fed thin-air credit, i.e., commercial bank cash assets, with the recent pick up in bank thin-air credit creation, the sum of commercial bank thin-air credit and Fed thin-air credit, is now growing year-over-year at its fastest pace since December 2005.

So, what does this have to do with inflation? Why do I assert that the seeds of U.S. inflation have sprouted? Well, U.S. asset prices have risen rather significantly. This is shown in Chart 2 in which I have charted the holding gains on U.S. household assets – direct and indirect holdings of financial assets and real estate – as a percent of nominal Gross Domestic Purchases (nominal dollar expenditures by U.S. households, businesses and governments on currently-produced goods and services). To smooth the data, I have presented the four-quarter moving average of this ratio.
Chart 2

In the four quarters ended Q1:2014, the latest data available, holding gains of U.S. household assets in relation to nominal Gross Domestic Purchases averaged 9.4%. Holding gains of this magnitude are closing in those experienced during the NASDAQ bubble of the late 1990s and the housing bubble of the mid 2000s. So, asset-price inflation is occurring currently. Hence, my assertion that that the seeds of U.S. inflation have sprouted.

But what about my prediction that U.S. inflation could be in full flower in 2016? The goods/services price data shown in Chart 3 do not indicate any similar current breakout in this kind of inflation as compared with the current breakout in asset-price inflation.
Chart 3

But might there be a breakout in goods/services price inflation in 2016? The historical relationship between thin-air credit growth and goods/services price inflation suggests as much. In the post-WWII era, the gestation period of goods/services price inflation relative to thin-air credit growth has tended to be long – about two years. So, what is happening to thin-air credit today will have its effect on goods/service price inflation in about two years from now, based on historical relationships. My data analysis indicates that in the past 60 years, the highest correlation between the year-over-year percent change in the implicit price deflator of Gross Domestic Purchases and the year-over-year percent change in thin-air credit (i.e., the sum of Fed and depository institution credit) is 0.55 out of maximum possible 1.00, which is obtained when thin-air credit leads the implicit deflator by nine quarters. This result is shown in Chart 4.











Chart 4

Whether the behavior of thin-air credit leads the behavior of goods/services price inflation by nine quarters or five quarters, the point is that it does lead and the lead time is relatively long. Thin-air credit currently is growing and has been growing for about a year at an historically rapid rate. Thus, one should not be sanguine about the prospects for continued mild goods/services price inflation just because this inflation currently is mild.

I said at the outset that my definition of inflation includes both the behavior of goods/services prices and asset prices. I also said at the outset that I believed that this inclusive concept of inflation resulted from monetary factors. Chart 5 shows the historical relationship between percentage changes in thin-air credit and my inclusive definition of inflation. (I wish the statistics gurus at the BLS, Commerce or the Fed would calculate a price index that included both goods/services prices and asset prices. But, given that no such index exists to the best of my knowledge, I have had to construct my own, crude as it is.) To construct my inflation measure, I have added together the four-quarter moving average of household asset holding gains as a percent of nominal Gross Domestic Purchases and the year-over-year percent change in the implicit price deflator of Gross Domestic Purchases. To account for historical lead-lag relationships, the percentage change in the implicit price deflator is lagged by nine quarters while the holding gains measure of asset-price inflation is contemporaneous. For example, the last “inflation” data point plotted in Chart 5 is for Q4:2011, which is the sum of the year-over-year percent change in the Gross Domestic Purchases implicit price deflator for Q1:2014 (remember, it is lagged by nine quarters) and the four-quarter moving average of household asset holding gains as a percent of nominal Gross Domestic Purchases for Q4:2011. Whew! The correlation between thin-air credit growth and “inflation” is 0.41. Although I typically do not get too excited about correlations below 0.50, given the crude nature of my “inflation” variable with one component measured contemporaneously and one component measured with a nine-quarter lag, a correlation of 0.41 is better than a poke in the eye with a stick. Moreover, the chart looks pretty good, save for 1984, which might reflect the oil glut of 1986 (remember, the implicit deflator change is lagged by nine quarters) and 2008, when thin-air credit soared as the Fed opened up the discount window and created other lending facilities to satisfy an increased demand for liquidity in the wake of financial institution solvency issues.
Chart 5

To summarize, as of July, the sum of commercial bank credit and Fed credit had increased 9.7 percent year-over-year despite a sharp slowing in Fed credit growth due to the winding down of QEIII. Growth in thin-air credit of this magnitude is high in an historical context. Persistent growth in thin-air credit of this magnitude typically results in rising inflation – asset-price inflation and/or goods/services-price inflation. The U.S. already is experiencing asset-price inflation. Given its historically long gestation period, a sharp acceleration in goods/services-price inflation is likely to be evident in 2016. Unless growth in commercial bank credit autonomously decelerates and/or the Fed soon takes more aggressive actions to restrain growth in the sum of bank and Fed credit, higher inflation, in the inclusive sense, will be “baked in the cake” over the next couple of years.

One final note. In addition to saying that inflation is a monetary phenomenon, Professor Milton Friedman also said that the lags between monetary variables and inflation are long and variable. Based on my empirical analysis, I agree with his conclusion regarding the long and variable lags. As a result of his analysis, Professor Friedman recommended 60 years ago that Fed policy be conducted so as produce a steady rate of growth in the quantity of some monetary variable. By so doing, the Fed could avoid unintentionally increasing the amplitude of inflationary cycles. Although I may humbly disagree with Professor Friedman’s choice of the monetary variable quantity whose growth rate the Fed should target, 60 years later I still agree with his premise. I believe that if the Fed were to operate such that thin-air credit grew at a steady and “reasonable” rate (its 61-year median growth rate is 7.4%), then the high goods/services-price inflations of the Burns-Fed era and the high asset-price inflations of the Greenspan-Fed era could be avoided. And by avoiding these extreme inflations in the future, we could avoid the extreme recessions in real output that inevitably ensue once the inflation “fevers” break.

Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic and Investment Advisor
Legacy Private Trust Company of Neenah, Wisconsin
1-920-818-0236





Tuesday, August 5, 2014

How Quantitative Easing "Works" -- The Mainstream Still Doesn't Get It

August 5, 2014

How Quantitative Easing “Works” - The Mainstream Still Doesn’t Get It

I’m not going to lie to you. I have had a mild case of writer’s block the past month. I have found that there is nothing better to summon my muse than to read what mainstream economic analysts/commentators are writing about current issues. Typically, I can find something they are saying that I vehemently disagree with.

Sure enough, it worked. While thumbing through my most recent copy of The Economist (August 2nd – 8th), I came across the Free Exchange section entitled “The Exceptional Central Bank.” The header on the article is: “The European Central Bank should adopt quantitative easing now rather than as a last resort.” I don’t have any disagreement with this header other than I would argue that the ECB should have adopted quantitative easing (QE) five years ago. No, what lit my fuse was the following:

“One of the main ways that QE has boosted the American economy is by lowering corporate borrowing costs. As the Federal Reserve bought Treasuries and government-guaranteed mortgage securities, pushing down their yields, investors turned to corporate bonds, in turn driving down their yields (emphasis added).”

Really? This is how QE has boosted the American economy, by lowering corporate bond yields? I disagree with this analysis on both empirical and theoretical grounds. Let’s start with the empirical evidence. Let’s observe how the yield on corporate bonds has behaved in relation to Fed purchases of Treasury coupon and agency mortgage-backed securities. These data are shown in the chart below. The Fed stepped up its securities purchases early in 2009. By the second quarter of 2010, its first phase of QE had ended. Corporate bond yields fell as the Fed ended QEI. The Fed again stepped up its securities purchases in the fourth quarter of 2010, terminating QEII in the second quarter of 2011. As the Fed initiated QEII, corporate bond yields trended higher. Following the termination of QEII, corporate bond yields plummeted. With the initiation of QEIII in the fourth quarter of 2012, corporate bond yields started rising. So, Fed purchases of securities in recent years have tended to be positively correlated with corporate bond yields. That is, when the Fed has stepped up its purchases of securities, corporate bond yields have tended to rise; when the Fed has cut back on its securities purchases, corporate bond yields have tended to fall. I guess the editors of The Economist hold to the maxim, “never let the facts get in the way of a good story”.


Except that it is not even a “good story” on theoretical grounds. Suppose one morning, all households decided to cut back on their spending by 10% and use these saved funds to purchase corporate bonds. Corporate bond yields would surely fall. For the sake of argument, assume that businesses in the aggregate increased their borrowing and spending by an amount equal to what households cut back on their spending (increased their lending). In this extreme case, the decline in corporate bond yields would elicit a net change in total spending in the economy of zero. In a more likely case in which the saving behavior of households was positively correlated with the level of interest rates (i.e., the supply curve of household lending sloped upward and to the right), all else the same, the increase in business borrowing/spending resulting from an outward shift in the household lending supply curve would be less than the cut in household spending (increase in household lending). So, a decline in corporate bond yields, in and of itself, is no guarantee of a net increase in aggregate spending on goods and services.

But what if there were an increase in credit that did not entail households cutting back on their current spending? What if some entity could create credit, figuratively, out of thin air? That is exactly what the Fed does when it purchases securities. Suppose the Fed purchases $100 worth of securities from a pension fund. The Fed pays for these securities by crediting the pension fund’s bank account by the amount of the securities purchase, $100. The pension fund has $100 more of deposits and $100 less of securities. The Fed has $100 more of securities, an asset to the Fed, and $100 more of reserves, a liability the Fed, owned by the pension fund’s bank. The pension fund’s increase in deposits and the increase in reserves owned by the pension fund’s bank were created by the Fed, figuratively out of thin air. If the pension fund decides to purchase some securities to replace those it sold to the Fed, then it will be using funds created by the Fed out of thin air to increase the supply of credit.

Assume that the pension fund purchases $100 of newly-issued corporate bonds to replace the $100 of securities it sold to the Fed. Further assume that the corporation issuing these bonds uses the proceeds of the bond sale to purchase $100 of new equipment. In this case, the increase in credit will result in a net increase in aggregate spending on goods and services because the increase in credit was created out of thin air, not as a result of households cutting back on their current spending in order to purchase the newly-issued corporate bonds.

The main way QE has boosted the American economy has been by the Fed creating credit out of thin air, enabling some entities to increase their current spending without requiring any other entities to cut back on their current spending. Contrary to what the editors of The Economist and many mainstream economic analysts assert (but don’t verify), QE has not boosted the American economy by lowering corporate bond yields.

Note: The views expressed in this commentary solely reflect those of Econtrarian, LLC.

Paul L. Kasriel
Econtrarian, LLC
1 920 818 0236
Senior Economic and Investment Advisor
Legacy Private Trust Co., Neenah, WI


Tuesday, June 24, 2014

Just Because the Fed Is Doing the Right Thing Now Is No Guarantee It Will Continue to Do So

June 24, 2014

Just Because the Fed Is Doing the Right Thing Now Is No Guarantee It Will Continue to Do So

The Fed is continuing to slow the growth in the amount of credit it is creating. In December 2013, the year-over-year growth in the sum of Fed outright holdings of securities and its net repurchase agreements (repurchase agreements minus reverse repurchase agreements) was 41.1%. As of May, the year-over-year growth in this sum had slowed to 24.8%. At the same time that growth in Fed credit creation has slowed, growth in commercial bank credit creation has increased. In December 2013, year-over-year growth in the break-adjusted commercial bank credit was 1.0%. As of May, year-over-year growth in break-adjusted commercial bank credit had risen to 3.6%. In the five months ended May, the compound annual growth rate (CAGR) of break-adjusted commercial bank credit was 7.4%. For reference, the median year-over-year growth in monthly observations of break-adjusted commercial bank credit in the past 38 years was 7.0%.  As shown in Chart 1, year-over-year growth in the sum of Fed credit and break-adjusted commercial bank credit was 8.5% in May compared to a 38-year median growth rate of 7.1%.

Chart 1
Chart 2 shows the deviation between the year-over-year percent change in the sum of Fed and adjusted commercial bank credit from 7.1%, the 38-year median of the year-over-year percent change in this credit sum. As one can see, the year-over-year percent change in the sum of Fed and bank credit had been “deficient”, often severely so, relative to its median from March 2008 through June 2013, with the exception of January 2010. But, as was stated above, in the 12 months ended May 2014, annualized growth in the sum of Fed and break-adjusted commercial bank credit was 8.5%, 150 basis points above its 38-year median percent change. So, the “drought” in the sum of Fed and adjusted commercial bank credit appears to have been broken with the combination of the resumption of Fed net acquisitions of securities in September 2012 and the recent acceleration in the growth of commercial bank credit.

Chart 2
As a “refresher”, the reason I pay particular attention to this credit sum is that growth in a variant of it has a strong association positive association with growth in gross domestic purchases (defined as gross domestic product plus imports minus exports). The credit variant includes, in addition to Fed credit and commercial bank credit, credit created by saving institutions and credit unions. Commercial banks, saving institutions and credit unions issue deposits that are redeemable at par. Thus, they are referred to as depository institutions. So, my credit variant is the sum of Fed credit and depository institution credit. As I have explained in previous commentaries, what distinguishes this credit variant from other measures of credit is that credit created by the Fed and depository institutions is credit created figuratively out of “thin air.” As such, it enables its recipients (borrowers) to increase their current spending while not requiring any other entity to pare back its current spending.

Plotted in Chart 3 are the year-over-year percent changes of quarterly observations in the sum of Fed and depository institution credit along with gross domestic purchases from Q1:1954 through Q1:2014. When the percent changes in thin-air credit were advanced by one quarter, a higher positive correlation (0.63) was obtained than with the two series compared contemporaneously or with changes in gross domestic purchases advanced by one quarter. This suggests that growth in thin-air credit “causes” growth in gross domestic purchases rather than vice versa. Because gross domestic purchases include only purchases of currently-produced goods and services, they do not capture spending or transactions on other things that additional thin-air credit might finance, e.g., purchases of financial assets or previously-produced real assets. I would argue that the correlation between changes in thin-air credit compared to total transactions would be higher than its comparison to gross domestic purchases. Regrettably, I am not aware of a series that measures total nominal transactions.

Chart 3


After an economically-depressing, not to mention, psychologically-depressing, severe winter, the U.S. economy appears to be responding predictably to the relatively rapid growth in thin-air credit. Chart 4 shows that both nominal retail spending on goods and the real production of goods have rebounded in growth in recent months. Chart 5 shows that growth in combined new and existing home sales has come roaring back. Chart 6 shows that the least-revised labor market data, the weekly state unemployment insurance benefit data, are indicating an improved labor market environment. Chart 7 shows that U.S. equity prices continue to climb. And Chart 8 shows that no matter how you slice it or dice it, the rate of increase in consumer prices for goods and services is accelerating.

Chart 4










Chart 5

Chart 6

Chart 7


Chart 8

The upshot of all this is that unless the Fed wants to create an undesirable inflationary environment in terms of asset prices and/or consumer prices of goods and services, it is time for the Fed to scale back its creation of credit, which it has been in the process of doing since the January 2014 commencement of its monthly tapering in the net acquisition of securities. The Fed also has stepped up the amount of its reverse-repurchase-agreement operations, which serve to reduce Fed credit, all else the same.

But the Fed pursuing the correct monetary policy today for reasons it does not understand instills little confidence that it will continue to pursue the correct policy tomorrow. When the Fed announced in September 2012 that it was going to resume its net acquisitions of securities, it did not say that it was doing so in order to boost the then anemic growth in thin-air credit. No, it justified the resumption of net acquisitions of securities in terms of lowering the yields on longer-maturity securities. The Fed never publicly explained how it decided that $85 billion of net securities acquisitions per month was the correct amount. Nor did it publicly explain why the $10 billion tapering of net securities acquisitions per FOMC meeting was the correct amount. The Fed continues to be obsessed with the price of credit, an interest rate, rather than the quantity of credit. Moreover, on those rare occasions when the Fed might mention the quantity of credit, it has never made a distinction between thin-air credit and all other credit. But then, neither have many other economic commentators, save for those of the Austrian School.

Let’s make some assumptions to give us an idea as to the likely behavior of thin-air credit over the next year and a half.  Assume that the Fed continues to taper its net acquisitions of securities by $10 billion per FOMC meeting, implying that by the December 2014 meeting, it would be making no net new outright acquisitions of securities to its balance sheet.  Assume that the Fed maintains the amount of its net repurchase agreements at a level equal to that of the average of the first five months of 2014, $245.9 billion. Lastly, assume that break-adjusted commercial bank credit continues to change at a CAGR of 7.4%, its annualized growth rate in the five months ended May 2014. Chart 9 shows the actual year-over-year percent changes in monthly observations of the sum of Fed and break-adjusted commercial bank credit from December 2008 through May 2014 as well as projected values through December 2015 based on the above assumptions.












Chart 9

At the end of 2013, this credit sum had increased by 9.2% vs. December 2012, primarily because of the Fed’s securities purchases. As of this past May, the year-over-year growth in this credit sum had moderated to 8.5% because of the Fed’s tapering of its securities purchases. If my assumptions regarding Fed and bank credit hold, then by December 2014, the sum of Fed and bank credit growth would have moderated further to 8.0% on a year-over-year basis.

Let’s pause here to contemplate what this would imply for the pace of economic activity and the behavior of financial markets. Back-to-back years of growth in the sum of Fed and bank credit of 9.2% and 8.0% represents robust growth in this variant of thin-air credit. After the weather-depressed first quarter of this year, I would be expecting a strong rebound in the pace of real economic activity over the remaining three quarters of 2014. I also would expect a continued modest upward trend in the growth of consumer prices for goods and services. If this relatively robust growth in nominal economic activity were to occur, it would create expectations of financial market participants that the Fed would start to raise its policy interest rates sooner than what the Fed is projecting. Thus, yields on Treasury securities from maturities of two years on out, would move higher over the remaining course of 2014. Although the stronger growth in nominal economic activity would be a plus for corporate profits, the rise in interest rates would represent a higher discount factor applied to corporate profits. Thus, although U.S. equity prices could continue to move higher in 2014, the rise in market interest rates would represent a headwind for equity prices.

But if my projections for growth in thin-air credit for 2015 are close to the mark, 2015 would be a more challenging year for real economic growth and the equity market. Slowing from 8.0% to 5.5% in thin-air credit growth would represent a significant deceleration. Depending on how the Fed reacts early in 2015 to stronger real growth and higher consumer price inflation in 2014 than it expected, even 5.5% growth in thin-air credit in 2015 might be hard to achieve. If things play out the way I expect in 2014, Fed hawks’ influence on monetary policy decisions would increase in early 2015. Thus, Fed interest rate hikes could come early in 2015. All else the same, these rate hikes would act as a brake on commercial bank credit creation. Thus, the 2015 7.44% CAGR in bank credit assumed in my projection could be too high, which, in turn, would render the assumed 5.5% growth in the sum of Fed and bank credit too high.

As I indicated at the outset, the slowing in Fed credit creation in 2014 seems entirely prudent to me. But I would have a lot more confidence in the correctness of Fed policy in subsequent years if I believed the Fed understood why it is correct to slow its credit creation in 2014. Without this understanding, there is a high likelihood of significant Fed policy mistakes in subsequent years.

I want to close on a note of personal humility. (As my brother, may he rest in peace, used to remind me, I have so much to be humble about.) In my projections of thin-air credit growth, I have made assumptions about Fed credit growth and commercial bank credit growth. I feel most confident about Fed credit growth and least confident about bank credit growth. After all, my assumption of 7.44% CAGR in bank credit going forward is nothing but the simplistic assumption that what happened in the past 5 months will persist in the next 19 months. Thus, the outlook for thin-air credit growth could change significantly in the weeks and months ahead. That is why every Friday afternoon I update my spreadsheet on it. If things do change significantly from what I have assumed here, I will alert you to this.

Paul L. Kasriel
Econtrarian, LLC
Senior Economic and Investment Adviser
Legacy Private Trust Co. of Neenah, WI
1 920 818 0236