Sunday, January 25, 2015

The Fed -- Lucky or Smart?

January 25, 2015

The Fed – Lucky or Smart?

Given the rapid growth in total thin-air credit, i.e., the credit created by the Fed and depository institutions, during most of 2014, the Fed was correct in phasing down the amount of securities it was purchasing if it wanted to avoid creating another asset bubble and/or an acceleration in price increases of goods and services. But when the Fed ended its securities-purchase program in October 2014, it appeared as though growth in total thin-air credit would slow precipitously in 2015 without some contribution from the Fed. This projected 2015 precipitous slowing in total thin-air credit prompted me to write a commentary entitled “2015 Is Shaping Up to Be a ‘Turkey’ of a Year for the U.S. Economy and Stock Market” on November 17, 2014. But, alas, something has changed since mid November. Namely, commercial banks have stepped up their thin-air credit creation markedly, partially compensating for the sharply-reduced Fed thin-air credit creation. As a result, if current trends persist, a big “if”, 2015 is beginning to look better in terms of the performance of the U.S. economy and risk assets than I anticipated in mid November of last year.

Chart 1 is reproduced from my November 17 commentary. The data at that time showed that year-over-year growth in the sum of bank credit and depository institution reserves at the Fed had slowed to 6.8% in October 2014 after having been in the range of 8.4% to 9.8% earlier in 2014. Assuming that bank credit would continue to grow at its October 2014 year-over-year rate of 6.5% and assuming that reserves at the Fed would remain constant at their October level, by December 2015, year-over-year growth in total thin-air credit would have slowed to 5.0%. If bank credit were to increase at a compound annual growth rate (CAGR) of 4.8%, its CAGR for the three months ended October 2014, then, assuming no growth in reserves at the Fed, total thin-air credit would have ended 2015 with year-over-year growth of just 3.9%. Either way, back in mid November 2014, it looked as though 2015 was shaping up to be a year of a sharp deceleration in the growth of thin-air credit.
Chart 1


But, a funny thing happened thereafter. Growth in bank credit accelerated. As shown in Chart 2, for the week ended January 14, 2015, year-over-year growth in bank credit has moved up to 8.3%. For the 13-weeks ended January 14, 2015, the CAGR in bank credit was 11.2%!
Chart 2
Even with the sharp deceleration in the growth of depository institution reserves at the Fed, growth in total thin-air credit is once again ascending, as shown in Chart 3. In the week ended January 14, year-over-year growth in total thin-air credit stood at 8.2%.
Chart 3
If growth in bank credit were to persist at its current year-over-year pace of 8.3% and reserves at the Fed were to remain at their current level, then a year from now, total thin-air credit will have increased by 6.6%. This compares with 8.2% growth in total thin-air credit in the 52 weeks ended January 14, 2015 and long-term median annual growth in total thin-air credit of about 7-1/2%. If total thin-air credit growth were to repeat in the next 52 weeks at the 8.2% it registered in the past 52 weeks, there would be increased risk of inflating an asset-price bubble and/or sowing the seeds of undesirably-high goods/services price inflation. So, bringing down the growth in total thin-air credit by about 150 basis points from it prior 52 weeks’ growth and to a rate about 100 basis points below its long-run normal growth seems to me to be a “smart” policy move on the part of the Fed.

When the Fed ceased its active program of securities purchases last October, did the Fed anticipate that growth in commercial bank credit would soon accelerate, partially offsetting the extreme depressing effect on total thin-air credit growth emanating from the Fed’s cessation of securities purchases?  Given that to my knowledge the Fed has never publicly rationalized its securities-purchase program in terms of augmenting the supply of credit in the economy nor has the Fed publicly commented on the quantity of depository institution credit being created, there is little reason to believe that the recent fortuitous acceleration in commercial bank credit, fortuitous for the economy and the stock market, was anticipated by the Fed. But if the Fed isn’t smart, being lucky is a good substitute. By either intelligence or luck, if the Fed has engineered growth in total thin-air credit of about 6-1/2% 52 weeks from now, 2015 will likely to have been a year of reasonably good economic growth and reasonably good stock market performance – not as good as 2014, but better than what things were shaping up to be in mid-November, 2014. But what if bank credit growth were to suddenly plunge? What luck could we count on for the Fed to resume securities purchases in order to prevent a sharp deceleration in the growth of total thin-air credit as was imminent back in mid-November, 2014?

Paul L. Kasriel
Founder & Musical Director, Econtrarian, LLC
1-920-818-0236

Sr. Economic & Investment Advisor, Legacy Private Trust Co., Neenah, WI

Sunday, December 21, 2014

The 2014 Festivus Airing of Grievances

Embargoed until 5 PM CST, December 23, 2014

The 2014 Festivus Airing of Grievances

Well, it’s that time of the year again for the airing of grievances.  And I’ve got a lot of problems with you people! First of which are those of you (PK, NYT?) who insist that the Fed’s QE did not result in any inflation. It all depends on your definition of inflation. If your definition is restricted to the prices of goods and services, you are right. No matter how you slice it or dice it, there has been no discernible upward trend in the price changes of consumer goods and services since the start late 2012 start of QE III, as shown in Chart 1.
Chart 1
If, however, you expand the definition of inflation to include the prices of assets, then there has been a discernible pick-up in inflation since late 2012. For households, their holding gains on assets (stocks, bonds, houses, e.g.,) scaled against the market value of their total assets have moved up noticeably since the onset of QE III in late 2012, as shown in Chart 2. In fact, asset inflation in 2013, according to this measure, was approaching the housing-bubble highs of 2005-06.
Chart 2
You don’t think that QE had anything to do with asset inflation starting in late 2012? Check out Chart 3, which shows the behavior of credit granted for the purchase and carrying of securities and thin-air credit, i.e., the sum of credit created by depository institutions and credit created by the Fed in the form of depository institution reserves held at the Fed and their vault cash. Perhaps asset-price inflation will moderate in 2015 as growth in thin-air credit does.
Chart 3

My next grievance with you people is your dark-cloud reaction to the recent decline in petroleum prices. When these prices rise, the talking heads warn of dire economic consequences. When they fall, the talking heads also warn of dire consequences. My approach to ascertaining whether the recent decline in energy prices is a “good” economic development for the U.S. economy, in particular, and the global economy, in general, is to keep in mind that more is better than less. That is, if more energy is available, then more of the final goods and services we consume can be produced. Think of an agriculturally-based economy. Which will contribute to higher standard of living for the residents of this economy – a bumper crop or a lost crop? The bumper crop, obviously. Similarly, more energy production is better than less energy production with regard to our standard of living. Chart 4 shows that U.S. energy production has been soaring in recent years. That’s a “good” thing, economically speaking.
Chart 4

Another grievance I have with you people is your Keynesian (probably not Keynes, himself, rather his subsequent interpreters) view of saving. How many times have you heard that if extra income goes to the rich, they will just save it, which won’t stimulate total spending in the economy?  But if income goes to the less rich, they will spend it, which will stimulate total spending in the economy. This popular view is that when people save, funds somehow disappear from the total spending stream of the economy. This popular view of saving is often advanced as an economic argument to buttress a moral argument for government-mandated income redistribution. But except in one case, this popular view of saving is fallacious.

What does it mean to increase your saving? It means you cut back on your current spending on goods and services relative to your income. When you cut back on your goods/services spending, what do you do with that saved income? You typically, directly or indirectly, purchase equities or bonds. In other words, you transfer some of your income, which you have voluntarily chosen currently not to spend on goods and services, to another entity, perhaps a business, a government or even another household, that currently wants to increase its spending relative to its income. So, in this case of increased saving by you, total spending on goods and services in the economy does not decline. Rather your decrease in current spending on goods and services is offset by an increase in spending by the entity that ultimately received the funds with which you purchased the stocks or bonds. So, if rich people are earning relatively more income than less rich people, total spending in the economy need not go down if the rich people save relatively more of their income. Rich people’s increased saving enables other entities to increase their current spending. The saved income does not vanish from the spending stream, as today’s Keynesian talking heads would have you believe. Rather, it gets transferred to others who are eager to increase their current spending. As an aside, if the increased saving by rich people funds spending on capital goods, all else the same, the economy’s future potential to produce goods and services is enhanced. In sum, increased saving is not a “bad” economic thing in the short run and is potentially a “good” economic thing in the long run.

 Income redistribution generally will not stimulate total spending in the economy. If income is taken from the rich and given to the less rich, the rich will react by either cutting back on their current spending and/or cutting back on their saving, which implies less spending by some other entity. Either way, the increased spending by the less rich will be offset by the decreased spending and/or saving by the rich. Thus, income redistribution will not result in a net increase in total spending in the economy. Again, there may be a moral argument for income redistribution, but there is not a macroeconomic reason for it.

Now, there is one case in which an increase in saving can lead to a decrease in total spending in the economy. If you increase your saving and choose to use your extra unspent income to increase your balances at depository institutions, total spending in the economy will decline, all else the same. But wait, doesn’t the bank lend the increase in funds it received from you? Probably. But the income you received but chose not to spend now came to you from the bank of some other entity. That bank has lost funds and, thus, has to reduce its loans. So, the result of you using increased saving to build up your deposits is net decline in goods/services spending in the economy. In the 1930s, when Keynes was advancing Keynesianism, this type of saving was referred to as hoarding “money”. Back in the Great Depression, when many businesses and depository institutions were failing, people preferred to save in the form of currency and/or in deposits at super-liquid banks because of the safety of principal of these types of assets. This saving in the form of cash, or hoarding, is what motivated Keynes to have a dim view of saving in his Keynesian macroeconomic theory. Although I suspect that Keynes understood the different implications regarding total spending in the economy between an increase in saving that took the form of stocks and bonds and an increase in saving that took the form of currency and deposits, it is not clear that current adherents to Keynesian macroeconomic theory understand this difference. For whatever reason, the term “hoarding” has gone out of fashion. We now refer to saving in the form of cash (either currency or bank deposits) as a decrease in the “velocity” of money. If a decrease in the velocity of currency and deposits is not countered with an increase in the supply of currency and deposits, then nominal spending in the economy will decrease.

I have one last grievance to air. This one, however, is not with you people. Rather it is with me, people! Throughout 2014, I had been telling you people to steer clear of bonds, especially investment-grade bonds, because I had thought that bond yields would rise. The reason I had thought bond yields would rise is that I also thought that 2014 growth in domestic nominal spending on goods and services would be stronger than the Fed and the consensus expected as a result of increased growth in thin-air credit. I figured that the Fed would be reluctant to pre-emptively raise the federal funds rate in 2014, but that market participants would anticipate more aggressive funds rate increases in 2015, which would result in higher bond yields in 2014. Well, growth in domestic nominal demand did turn out to be relatively robust in 2014, save for a weather-depressed first quarter. And the Fed did not raise its policy interest rates in 2014 nor even seriously threaten to do so. But Treasury bond yields did not rise during 2014. As Chart 5 shows, Treasury bond yields actually fell. The yields that did rise were those on shorter maturity Treasury coupon securities, as represented by the yield on the 2-year Treasury security in Chart 5. Perhaps market participants believe that the Fed will raise its policy interest rates in 2015 sufficiently to slow growth in economic activity in 2015 and 2016 such that goods/services price inflation will stay in check. And given the pronounced slowdown in the growth of thin-air credit in the closing months of 2014, this market “bet” might be right.
Chart 5

But I was dead wrong on the direction of bond yields in 2014. So, I’ve been pinned. That means that the airing of grievances is over for 2014 and the Festivus celebrations can now begin in earnest. Gather around your Festivus poles, preferably made of aluminum because of its high strength-to-weight ratio, and join me in singing the Festivus Carol.

A Festivus Carol
(Lyrics by Katy Kasriel to the melody of O’ Tannenbaum)

O’ Festivus, O’ Festivus,
This one’s for all the rest of us.
The worst of us, the best of us,
The shabby and well-dressed of us.
We gather ‘round the ‘luminum pole,
Air grievances that bare the soul.
No slights too small to be expressed,
It’s good to get things off our chest.
It’s time now for the wrestling tests,
Feel free to pin both kin and guests,
Festivus, O’ Festivus,
The holiday for the rest of us.

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






Sunday, November 16, 2014

2015 Is Shaping Up to Be a "Turkey" of a Year for the U.S. Economy and Stock Market

November 17, 2014

2015 Is Shaping Up to Be a “Turkey” of a Year for the U.S. Economy and Stock Market

On November 24, 2013, I penned a piece entitled “Unless the Fed Goes Cold Turkey on Us, Expect a Bountiful Economic Harvest for Thanksgiving 2014”. In it I argued that 2014 would be a good year for the U.S. economy and U.S. risk assets, such as equities, because I expected a year of robust growth in “thin-air” credit, i.e., the combined credit created by the Federal Reserve and the U.S. depository institution system, primarily commercial banks. Although thin-air credit has not grown as rapidly as I had projected, largely because the Fed tapered its securities purchases more aggressively than I had assumed, still, thin-air credit grew at a relatively robust pace for most of the past 12 months.  And, despite a weather-induced weak first quarter of economic activity, the economy has performed quite well since Thanksgiving 2013. In the 12 months ended October 2014, U.S. car and light truck sales clocked in at 16.2 million units, the highest 12-month unit-sales volume since June 2007. In both September and October 2014, the unemployment rate for those covered by state unemployment insurance programs stood at a seasonally-adjusted level of 1.8% -- the lowest unemployment rate since May 2006. In October 2014, the ISM-Manufacturing production index stood at 64.8, its highest level since May 2004. For the week ended November 14, 2014, the Wilshire 5000 stock market index, a proxy for all U.S.-traded equities, reached a record high and was up 13.3% from its year-ago weekly average. In the aggregate, then, I think it safe to say that we have enjoyed a bountiful economic harvest here in the U.S. in the past year.

If relatively robust growth in thin-air credit was a major factor accounting for 2014’s bountiful U.S. economic harvest, as I believe it was, then 2015’s “harvest” is likely to be considerably less bountiful. Growth in thin-air credit has already begun to decelerate and is on course to further decelerate in 2015. As mentioned above, the Fed curtailed its purchases of securities more aggressively than I had reckoned a year ago and ended its purchase program in October 2014. Although bank credit has grown considerably faster than I had anticipated, it is not fast enough to compensate for the slowdown in the growth of Fed thin-air credit.

Plotted in the chart below are actual and projected monthly observations of year-over-year percent changes in the sum of commercial bank credit and reserves held by these banks and other depository institutions at the Federal Reserve. The actual data are through October 2014, with the projections running from November 2014 through December 2015. There are two separate projections, both of which assume that reserves held at the Fed (the Fed’s contribution to thin-air credit) remain constant at the actual October level. When the Fed is not engaged in a quantitative easing (QE) policy, reserves of depository institutions held at the Fed typically grow less than 1% annually. In the 12 months ended October 2014, bank credit grew by 6.5%. So, in the first projection of thin-air credit growth, I assume that bank credit increases each month at a compound annual growth rate (CAGR) of 6.5% and reserves held at the Fed remain constant. In the 3 months ended October 2014, bank credit increased at a CAGR of 4.8%. So, in the second projection of thin-air credit growth, I assume that bank credit increases each month at a CAGR of 4.8% and, again, reserves held at the Fed remain constant.








After reaching a recent peak in growth of 9.8% in July 2014, year-over-year growth in thin-air credit decelerated to 6.8% in October 2014. A deceleration in growth of three percentage points in three months is severe in and of itself. But, wait. There is more, or less, as the case may be. With reserves at the Fed constant, if bank credit increases at a CAGR of 6.5% going forward, its October 2014 year-over-year increase, then the year-over-year growth in thin-air credit, i.e., the sum of bank credit and reserve balances at the Fed, will further decelerate to 5.0% by December 2015. With reserves at the Fed constant, if bank credit increases at a CAGR of 4.8%, its CAGR in the three months ended October 2014, then the year-over-year growth in thin-air credit will decelerate to 3.9% by December 2015. To put all of these growth rates into context, the median year-over-year change in monthly observations of the sum of bank credit and reserve balances at the Fed from December 1977 through December 2006 was 7.4%.

As U.S. thin-air credit growth is on track to slow in 2015, thin-air credit growth in the eurozone and in Japan is likely to accelerate as the European Central Bank and the Bank of Japan step up their QE programs. These foreign QE programs could indirectly stimulate U.S. exports. But the dominant factor affecting the U.S. economy in 2015 will be below-normal growth in U.S. thin-air credit. So, as you gather your family around you on Thursday, November 27, to give thanks for our bountiful 2014 economic harvest, bear in mind that next year’s harvest is likely to be a “turkey” in comparison.

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

http://www.the-econtrarian.blogspot.com

Saturday, October 18, 2014

A Tale of Two Economies -- It Was the Better of Times, It Was the Worst of Times

October 18, 2014

A Tale of Two Economies – It Was the Better of Times, It Was the Worst of Times

As quantitative easing comes to an end (apparently) by the Fed and is taken up by the European Central Bank (ECB), let’s compare the behavior of nominal domestic demand in each central bank’s economy and venture a reason for any differences.

Plotted in Chart 1 are index values of the nominal Gross Domestic Purchases in the U.S. and the eurozone, respectively. Each index is set at a value of 100 for Q4:2008. Since Q4:2008, Gross Domestic Purchases in the U.S. increased a net 18% through Q2:2014 (that is what the index value of 118 indicates). For the eurozone, Gross Domestic Purchases increased a net of only 3% in this same time period. In terms of compound annual growth rates over this period, the U.S. experienced growth of 3.0% and the eurozone, just 0.5%.
Chart 1

Now, let’s examine the behavior of credit created by the central banks and depository institutions in each of these economies. This is credit that is created figuratively out of thin air. When central banks purchase securities in the open market, such as they do when they engage in quantitative easing (QE), they create credit out of thin air. When the depository institution system expands its loan and securities portfolios, it creates credit out of thin air. Credit created out of thin air enables the borrower to increase his/her current nominal spending while not requiring any other entity to reduce its current spending. Plotted in Chart 2 are index values of the sum of central bank and depository institution credit outstanding for the U.S. and the eurozone, respectively. Each index is set at a value of 100 for Q4:2008. Since Q4:2008, U.S. thin-air credit increased a net 28% through Q2:2014, which works out to be a 4.6% compound annual rate. In this same period, eurozone thin-air credit has contracted a net 2%, or at a compound annual rate of minus 0.4%.



Chart 2

The Fed has engaged in QE in three separate phases in recent years, the first of which commenced in Q1:2009. From the end of Q4:2008 through the end of Q2:2014, U.S. thin-air credit increased a net $3.692 trillion, 82% of which was contributed by the Fed. During this same time period, the compound annual rate of growth in depository institution thin-air credit was only 1% rounded. Recall, that the sum of Fed and depository institution thin-air credit grew at a compound annual rate of 4.6% during this 22-quarter period vs. a long-run median annual growth rate of 7.4%. During this period, the ECB has refrained from engaging in QE and eurozone thin-air credit has contracted on net. Had the Fed not engaged in QE, U.S. total thin-air credit growth would have been quite weak, similar to what the eurozone has experienced.

A clue as to why depository institution thin-air credit creation has been weak in both the U.S. and the eurozone can be found in former Fed Chairman Bernanke’s recent revelation that he was unable to refinance his home mortgage. The explanation for weak depository institution thin-air credit creation is not so much related to lack of demand for it, but rather depository institutions’ inability to supply demanded credit. Following the bursting of the residential real estate bubbles in the U.S. and the eurozone, depository institutions experienced a severe “evaporation” of capital. Because of capital constraints, depository institutions were not able to expand their holdings of loans and securities. In the U.S., depository institutions relatively quickly began repairing their capital deficiencies. At the same time, however, regulators increased capital requirements and imposed more stringent liquidity and other regulatory requirements on depository institutions. Thus, while someone with a relatively high, but variable income, similar to Ben Bernanke’s current financial situation, would have had no difficulty in qualifying for a mortgage in 2001, he now has greater difficulty.

If Ben Bernanke had looked at some of the Fed survey data when he was Fed chairman, he would not have been surprised that he might have difficulty refinancing his mortgage once he became a “free agent”.  Plotted in Chart 3 are the responses to the Fed’s quarterly Senior Loan Officer Survey of bank lending terms related to residential prime mortgage applications. As the housing bubble began deflating in late 2007, the percentage of banks tightening their prime mortgage terms began rising, skyrocketing in 2008. Although the percentage of banks tightening their mortgage lending terms tailed off significantly by 2010, the percentage actually beginning to ease their lending terms has only begun to meaningfully rise in 2014.
Chart 3

The Fed conducts another quarterly survey that relates to banks’ willingness to lend, the Survey of Terms of Business Lending. Plotted in Chart 4 are the survey results showing the average rate charged by banks in the survey on all commercial and industrial (business) loans minus the Fed’s target federal funds rate. From Q3:1986 through Q4:2007, the median loan spread was 1.99 percentage points. The median spread from Q1:2008 through Q3:2014 rose to 3.05 percentage points, with the spread in Q3:2014 being 2.61 percentage points. These higher spreads following the financial crisis indicate banks’ inability to supply demanded credit because of capital constraints and/or increased regulatory scrutiny.





Chart 4

In case you hadn’t noticed, I have been attempting to make the case that the Fed’s engagement in QE and the ECB’s lack of QE account for the difference in the performance of the U.S. economy vs. the eurozone economy since 2008. But for all you Keynesians out there, what about federal fiscal policy, in particular federal spending? Some Keynesians (Krugman?) make the argument that the fiscal austerity in the eurozone is what has held back aggregate eurozone economic activity. Contrary to what some op-ed writers in The Wall Street Journal (Wesbury?) might have you believe, there has been fiscal austerity in the eurozone. In the five years ended 2013, the latest complete data I have, eurozone central government nominal spending grew at a compound annual rate of just 1.5%. And again, despite what some other op-ed writers in The Wall Street Journal (editorial board?) might have you believe, there also has been fiscal austerity in the U.S. To wit, in the six fiscal years ended 2014, total federal government nominal spending grew at a compound annual rate of 2.7% compared to a median annual change of 5.5% from FY 1981 through FY 2008. Total U.S. federal government expenditures in FY 2014 were actually $13.5 billion below those of FY 2009! Admittedly, federal government expenditures did soar in FY 2009 vs. FY 2008 because of TARP,  the American Recovery and Reinvestment Act of 2009 (Obama’s fiscal stimulus) and “automatic stabilizers” such as unemployment insurance and food stamps.





The point is that in both the U.S. and the eurozone, there has been fiscal austerity in recent years. Yet, U.S. aggregate domestic demand has been considerably stronger than that of the eurozone. The tale of the two economies is that in one, the U.S., the Fed pursued a QE policy, resulting in the better of times. In the other, the eurozone, the ECB eschewed a QE policy, resulting in the worst of times.

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