Monday, April 16, 2018

Thin-Air Credit Growth Slowdown Augurs Poorly for 2018 Domestic Demand Growth

April 16, 2018

Thin-Air Credit Growth Slowdown Augurs Poorly for 2018 Domestic Demand Growth

A majority of my readers (two) have asked me to update the discussion about the behavior of thin-air credit or a variant thereof, namely the sum of commercial bank credit (loans and securities) and the monetary base (bank reserves at the Fed and currency). To paraphrase the motto of the former iconic Chicago department store, Marshall Field’s, give the customers what they want. To give the “customers” a preview of what they are going to get, let me state that thin-air credit growth has slowed to a rate that is low both from a long-run and short-run perspective. The slowing growth in nominal thin-air credit in conjunction with the acceleration in consumer price inflation has negative implications for growth in real U.S. aggregate domestic demand in 2018. In turn, if growth in real aggregate domestic demand “surprises” on the downside in 2018, then the Fed is unlikely to hike the federal funds rate the full 50 basis points this year that the market currently expects. Alternatively, if the Fed is hell-bent on raising the federal funds rate 50 basis points or more over the remainder of 2018, it would be sowing the seeds of a 2019 recession unless there is an acceleration in the growth of nominal and real thin-air credit. An acceleration in the growth of thin-air credit would be unlikely in the face of a rising federal funds rate.

As shown in Chart 1, year-over-year growth in thin-air credit has trended lower from its 9+ percent observations from Q4:2013 through Q3:2014. As of Q1:2018, year-over-year growth in thin-air credit was 2.7% -- low growth in terms both of a long-run and short-run historical perspectives.
Chart 1
Plotted in Chart 2 are the year-over-year percent changes in the quarterly observations of, again, thin-air credit (the sum of commercial bank credit and the monetary base) along with the percent changes in each of its major components – commercial bank credit and the monetary base – by themselves. The slowing growth in thin-air credit (the red line) in 2015 and 2016 was primarily due to the Fed’s cessation of quantitative easing (QE), i.e., large outright purchases of government securities and quasi-government mortgage-backed securities, which resulted in the year-over-year contractions in the monetary base (the green bars). Surprisingly, at least so to me, was the rebound in year-over-year growth in the monetary base in the past three quarters inasmuch as the Fed had started to reduce, albeit marginally, its outright holdings of securities and the Fed had been hiking the federal funds rate. Starting in 2017 and continuing through the first quarter of 2018, growth in commercial bank credit the blue line) has been trending lower, which has restrained the growth in thin-air credit.
Chart 2
Not only has growth in nominal thin-air credit slowed, but so, too, has growth in real thin-air credit, i.e., nominal thin-air credit deflated by the Consumer Price Index (CPI). In Q1:2018, the year-over-year percent change in real thin-air credit was just 0.5%. The importance of this is that there is a relatively high correlation between the year-over-year growth in real thin-air credit and real final sales to domestic purchasers. Starting in Q1:2011, the correlation coefficient between the year-over-year percent changes in real final sales to domestic purchasers and the year-over-year percent changes in real thin-air credit, advanced two quarters, is 0.68 out of maximum possible 1.00. This is shown in Chart 3.


Chart 3
As one of my readers (the other one?) has correctly pointed out, correlation does not necessarily imply causation. However, when I tested the lead-lag relationships between these two series, I found that the correlation coefficient was highest when thin-air credit growth leads growth in real final sales to domestic purchasers by two quarters. When growth in real final sales to domestic purchasers leads growth in real thin-air credit, the correlation coefficient declines. This does not prove that growth in thin-air credit causes growth in real final sales to domestic purchasers, but it sure does support the hypothesis.

In sum, the slowing in the growth of both nominal and real thin-air credit augurs poorly for the growth in aggregate domestic demand in 2018. But wait, won’t this year’s federal tax cuts stimulate demand? Not unless the resulting increased deficits are financed with the creation of thin-air credit. (See my January 22, 2018 blog post “No Sugar High from Tax Cut Unless the Fed and the Banking System Provide the Sugar” for an explanation of this). And, so far, at least, growth in thin-air credit has slowed, not accelerated. The market currently expects the Fed to hike the federal funds rate at least another 50 basis points this year. If I am right that growth in domestic demand slows this year, a further 50 basis point increase in federal funds rate might be sowing the seeds of 2019 recession. Available data, such as annualized growth in Q1:2018 nominal retail sales of 0.8% vs. 10.4% in Q4:2017, suggest a slowing in the growth of Q1:2018 final sales. Rumor has it that the Fed believes this slowing in aggregate demand growth is mainly due to “faulty” seasonal adjustment factors. The Fed ought to take a look at the behavior of thin-air credit growth before dismissing the weakness in first quarter final sales growth.

Paul L. Kasriel, Founder, Econtrarian, LLC
Senior Economic and Investment Advisor
“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swart                                            ∆ + 6 = A Good Life


Sunday, April 1, 2018

As of this Past Fourth Quarter, the S&P 500 Remained Relatively Cheap

April 2, 2018

As of this Past Fourth Quarter, the S&P 500 Remained Relatively Cheap

Now that the first quarter of 2018 has just ended, what could be more fitting than to look back at the relative valuation of the S&P 500 stock index as of last year’s fourth quarter? After all, isn’t that what we economists do best, look back? This commentary is an update to my November 29, 2017 commentary, “The S&P 500 Is Not Expensive According to the Kasriel Valuation Model”. Before reviewing my methodology for estimating the over/under valuation of the S&P 500 stock market index, let me give you the Q4:2017 results upfront. According to my methodology, the S&P 500 index in Q4:2017 was overvalued by 7.4% compared with a revised 4.1% overvaluation in Q3:2017. Given that the median value of over/under valuation of my methodology in the period Q1:1964 through Q4:2017 was 35.5% overvaluation, the 7.4% overvaluation of the S&P 500 in Q4:2017 seems trivial. The continued low level of the corporate bond yield is the principal factor keeping the S&P 500 from being more materially overvalued.  Now for the important disclaimer. My relative valuation methodology involves only three observable variables – smoothed annualized reported earnings of corporations included in the S&P 500 equity index, the level of the corporate BAA/A-BBB bond yield and the actual market capitalization of the S&P 500. My methodology does not take into consideration expectations of corporate earnings or of bond yields. Nor does it take into consideration exogenous “shocks” including but not restricted to the likelihood of changes in the U.S. tax code, of geopolitical conflicts or of the imposition of U.S. trade protectionist policies. Of course, if I had a high degree of certainty about these exceptions to my “model”, I would be an extremely wealthy person and would not be inclined to share my “wisdom” with you!

To refresh your memory about my methodology, I calculate a quarterly theoretical market capitalization for the S&P 500 by discounting (dividing) smoothed annualized reported earnings of S&P 500 corporations by the yield on the lowest-rate investment-grade corporate bonds (BAA/A-BBB). I then compare my calculated theoretical market capitalization value with the actual market capitalization value. The percent of over/under value for the S&P 500 is calculated as follows:

((Actual Market Cap/Theoretical Market Cap)-1)*100

The technique I use to smooth reported corporate earnings is some high-falutin’ econometric technique called the Hodrick-Prescott filter. (Edward Prescott is a Nobel Prize winner in economics.) This smoothing technique is designed to remove the cyclical variation from a trending series. Another economics Nobel Prize winner, Robert Shiller, uses a 10-year moving average to smooth the S&P 500 price-to-earnings ratio in his stock market valuation research. He calls this the cyclically-adjusted P/E. It seems to me that a 10-year moving average is an arbitrary tool to use to remove the cyclical component from a time series. Why not use a technique specifically designed to remove cyclicality? While I’m on the subject of the Shiller cyclically-adjusted P/E, aside from the arbitrariness of using a 10-year moving average, a P/E in isolation tells you nothing about the stock market’s over/under valuation without taking into consideration the level of bond yields. A low P/E could be an indication of an overvalued stock market if the bond yield is relatively high. Conversely, a high P/E could be an indication of an undervalued stock market if the bond yield were relatively low, as has been the case for several years now.

Let’s go to the data. Plotted in the chart below are the quarterly observations of the percent over(+)/under(-) valuation of the S&P 500 calculated with my methodology discussed above. Also plotted in the chart are quarterly observations of the year-over-year percent change in the S&P 500 equity index. If my methodology has any legitimacy, there should be a negative correlation between the over/under valuation variable and the year-over-year percent change in the S&P 500 index. That is, if the S&P 500 is overvalued as calculated by methodology, then I would expect the S&P 500 equity index to be increasing at a slower rate or even declining. I found that the highest absolute value of a negative correlation coefficient, minus 0.20, is obtained when the over/under valuation is advanced by five quarters in relation to the year-over-year percent change in the S&P 500 index.  (With the low value of the correlation coefficient at minus 0.20, there obviously is a lot missing from this “model” in terms of explaining the behavior of the stock market, as I admitted at the outset.) So, the last data point plotted in the chart for the over/under valuation variable at Q1:2019 is actually the observation for Q4:2017 (advanced five quarters). The median value of over/under valuation is 35.5%. So, interpreting whether the S&P 500 is over or undervalued, it is better to look at the percent over/under valued in terms of 35.5% rather than zero.


As of Q4:2017, then,  my “model” indicated that the S&P 500 was overvalued by 7.4% -- a relatively low reading in comparison to the 35.5% median value for over/under valuation during the entire sample period. The yield on the BAAA-BBB corporate bond yield appears to have averaged about 4.45% in Q1:2018, up about 18 basis points from its Q4:2017 level. The market cap of the S&P 500 was about $22.5 trillion. If annualized smoothed S&P 500 reported earnings remained at their Q4:2017 level of $906.7 billion, then the S&P 500 would be 10.4% overvalued in Q1:2018 – still well below the median overvaluation of 35.5%. What if the BAA corporate bond yield had risen 100 basis points in Q1:2018 to a level of 5.27% and annualized smoothed reported S&P 500 earnings remained the same as they were in Q4:2017. In this case, in relation to the actual S&P market cap in Q1:2018, the S&P 500 would have been 31% overvalued. Of course, if the bond yield had risen by 100 basis point in Q1:2017, it is likely the actual S&P 500 market cap would have been significantly lower, and thus, the overvaluation of the market would also have been lower.

In sum, given S&P 500 annualized smoothed reported earnings and the current level of corporate bond yields, the S&P 500 stock market does not appear to be excessively overvalued. The continued low level of corporate bond yields is the principal reason that the overvaluation of the S&P 500 remains low in an historical context. Corporate earnings are growing, but at a subdued pace. In full disclosure, my portfolio is devoid of equities even though I do not believe that the S&P 500 is grossly overvalued.  Why? Because of those other factors that I mentioned earlier in this commentary. As evidenced by the quote I put at the end of my commentaries -- for most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal – I am congenitally risk averse. The S&P 500 equity index exhibited increased volatility in Q1:2018. I believe that this increased volatility was due primarily to exogenous “shocks” mentioned earlier in this commentary rather than the behavior of corporate earnings and/or corporate bond yields.

Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic and Investment Advisor

“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte

∆ + 6 = A Good Life







Monday, March 5, 2018

The Expected Widening in the U.S. Federal Budget Deficit Has Trade Protectionist Implications

March 5, 2018

The Expected Widening in the U.S. Federal Budget Deficit Has Trade Protectionist Implications

With the recent U.S. congressional passing and presidential signing of the Tax Cuts and Jobs Act of 2017 and the Bipartisan Budget Act of 2018, the federal budget deficit is projected to increase in the next few years. According to projections by the nonpartisan Committee for a Responsible Federal Budget, the U.S. federal budget will rise from $665 billion in fiscal year (FY) 2017 to $753 billion in FY 2018 and $1.1 trillion in FY 2019. Unless these increased federal budget deficits are financed out of increased U.S domestic saving, they imply increased financing from the rest of the world. Increased lending to the U.S. from the rest of the world implies a widening U.S. trade deficit. President Trump appears to have viewed the persistent U.S. trade deficit a result of “unfair” trade practices on the part of some U.S. trading partners. (I presented a counter argument to this view in my November 17, 2017 commentary entitled
At Least We Can Be Thankful to the ‘11’ Fair Traders”.) The Trump administration has imposed import tariffs on solar panels and washing machines recently and has announced its intention to impose import tariffs on steel and aluminum because of perceived unfair trade practices on the part of trading partners. If past is prologue, a widening in U.S. trade deficits resulting from widening U.S. federal budget deficits in the next couple of years could trigger more protectionist actions by the Trump administration.

Let’s look at some data to build a case that U.S. federal budget deficits are related to U.S. trade deficits. Plotted in Chart 1 are annual observations of U.S. net exports of goods and services from 1970 through 2017. Net exports are exports minus imports. So, if net exports are negative, it means that the value of goods and services imported by a country are is greater than the value of its exports. If net exports are negative, it means that a country is running a trade deficit. The data in Chart 1 show that the U.S. has consistently been running trade deficits from 1976 through 2017.
Chart 1
When a country runs a trade deficit, it means that the residents of that country are spending more on goods and services than they are producing. To see this, let’s look at the identity for GDP:

(1)   GDP = Goods & Services Spending + (Exports – Imports)

GDP is the value of goods and services produced in an economy. Goods and Services Spending is the aggregate spending by households, businesses and government entities.   Imports enter the GDP identity with a negative sign in order to avoid double counting. That is, imports account for some of the Goods & Services Spending.  Because GDP represents the value of goods and services produced in an economy, imports need to be subtracted from Goods & Services Spending. Because exports are not part of domestic Goods & Services Spending but are produced in the economy, exports are added to Goods & Services Spending.

By rearranging the terms in identity (1), we get:

(2)   GDP – Goods & Services Spending = (Exports – Imports)

If the term (Exports – Imports) is negative, that is, a country is running a trade deficit (net exports are negative), then GDP minus Goods & Services Spending also must be negative.  So, a country that is running a trade deficit, by definition, is spending more on goods and services than it is producing. The only way a country can spend more on goods and services than it produces is to receive goods and services from other countries. Unless the residents of those countries providing goods and services to the country running a trade deficit are gifting those goods and services, the residents of the trade-deficit- running country are either incurring debt or are selling off assets to the residents of the country providing the goods and services. In sum, a country running a trade deficit is, in effect, a net borrower from the rest of the world.

Plotted in Chart 2 are annual observations of U.S. net exports, the same as in Chart 1. But also plotted are the annual observations of net financial lending or borrowing by the combined U.S. nonfinancial sectors – households, nonfinancial business and government entities. The positive correlation between these two series for the period 1970 through 2016 is 0.81 (looks like 0.61 in Chart 2, but is 0.81). Recall, if the correlation were “perfect”, its value would be 1.00. So, the data in Chart 2 are supportive of the notion that as a country runs a wider trade deficit, its net financial borrowing increases, too.
Chart 2
Chart 3 shows from whom most of the borrowing comes when the U.S. runs a trade deficit – the rest of the world, obviously. The negative correlation between U.S. nonfinancial sector net borrowing and the rest of the world’s net lending to the U.S. is minus 0.78 for the years 1970 through 2016.
Chart 3
Okay, what does all this have to do with widening U.S. federal government budget deficits resulting in wider U.S. trade deficits? The data in Chart 4 have a bearing on this question. Plotted in Chart 4 are annual observations of net lending/net borrowing of the entire U.S. nonfinancial sector, including the federal government sector, and the net lending/net borrowing of the federal government sector by itself. The correlation between these two series is a positive 0.64. This suggests that the federal government budget deficit plays an important role as to whether the entire nonfinancial sector is in a net lending or net borrowing position. And again, if the entire nonfinancial sector is in a net borrowing position, there is a high probability that the U.S will be running a trade deficit, with the magnitude of the trade deficit positively correlated with the magnitude of the net borrowing position of the nonfinancial sector, as shown in Chart 2.








Chart 4


So, we have established that the magnitude of the U.S. trade deficit is highly correlated with the magnitude of the U.S. nonfinancial sector net borrowing position. The magnitude of the U.S. nonfinancial sector borrowing position is correlated with the magnitude of the U.S. federal government budget deficit. Nonpartisan analysts are projecting higher federal government budget deficits in the next two years. Thus, there is a high probability that the magnitude of the U.S. nonfinancial sector net borrowing position will increase in the next two years and with it, an increased magnitude in the U.S. trade deficit.

There is a possibility that the likely widening in the federal budget deficit would not result in a widening U.S. trade deficit. That possibility rests on whether the nonfinancial sector, excluding the federal government, increases its net lending to the federal government to prevent the total nonfinancial sector, including the federal government, from slipping further into a net borrowing position. This is unlikely to happen if the federal budget deficit reaches $1 trillion+ in FY 2019. That would be a $335+ increase in budget deficit vs. FY 2017. In the three quarters ended Q3:2017, net lending by the nonfinancial sector excluding the federal government amounted to $415 billion. So, net lending by the nonfinancial sector excluding the federal government would have to increase by about 80% to prevent total nonfinancial sector net borrowing from widening and, thus, the U.S. trade deficit from widening. Possible, but not probable.

At the outset of this commentary, I noted that President Trump interprets the persistence of U.S. trade deficits as evidence of “unfair” trade practices on the part of some of our trading partners. If the federal government budget deficit widens as credible analysts project, there is a high probability that the U.S. trade deficit also will widen. This could prompt the Trump administration to adopt even more protectionist trade measures given its view of the cause of trade deficits.


Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic and Investment Advisor

“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte

∆ + 6 = A Good Life




Sunday, January 21, 2018

No Sugar High from Tax Cut Unless the Fed and Banking System Provide the Sugar

January 22, 2018

No Sugar High from Tax Cut Unless the Fed and Banking System Provide the Sugar


There has been chatter about whether the Tax Cuts and Jobs Act of 2017 (TCJA) will result in a temporary stimulus, or sugar high, to U.S. economic activity because of the increase in corporate after-tax profits and the increase in household disposable income that will flow from the tax-rate cuts. How can putting this extra after-tax income in the hands of businesses and households not stimulate private sector spending? In order to answer this question, you have to follow the money. And when I follow the money completely, I come to the conclusion that the tax cuts will not stimulate private sector spending unless the Fed and the banking system finance the tax cut. In other words, TCJA will not produce an economic sugar high unless the Fed provides the sugar.

If the federal government cuts our taxes, all else the same, its budget deficit will increase. The tax cut in the short run, at least, will result in lower federal government tax revenues. That’s what increasing corporate after-tax profits and household disposable income is all about. But unless the federal government simultaneously cuts its expenditures to match the drop in its revenues, its budget deficit will increase. A wider budget deficit means an increase in federal government borrowing. Now we are getting to the nub of the issue – the implications of the funding of the tax cut. I argue that unless the Fed and the banking system create the – here it comes – thin-air credit to finance the tax cut, there will be no temporary stimulus from said tax cut.

Let’s assume that there is no additional thin-air credit (sum of bank credit, Fed reserves and currency) created in reaction to the tax cut. In this case, the extra funds needed to fund the wider deficit will have to be raised from the nonbank nonfederal government sectors – households, businesses, nonfederal government entities and the rest of the world. Because the U.S. Treasury cannot require these sectors to fund the federal government’s widened deficit, market forces must induce these sectors to voluntarily offer up these funds. The yield on Treasury securities would be expected to rise sufficiently to induce these sectors in the aggregate to reduce their current spending on goods and services by the amount of the increased federal budget deficit and transfer this purchasing power to the Treasury through the purchase of its additional securities offerings.

Let’s net all of this out. Some households and businesses that experience an increase in disposable income from TCJA might increase their current spending on goods and services. But because the wider federal budget deficit must be financed and we have stipulated no increase in thin-air credit, some entities in the household, business, nonfederal government and foreign sectors must cut their current spending on goods and services by the amount that other entities increased their current spending on goods and services. TCJA results in the federal government dissaving more and the other sectors saving more. The net result of this is that TCJA would not result in a net increase in current spending on goods and services. Rather, the increased current spending by some is offset the increased saving by others. TCJA, under these conditions, would not produce an economic sugar high.

Let’s look at some data. The blue bars in the chart below are the annual observations of the net lending (+) or net borrowing (-) of the U.S. federal government borrowing from 1965 through 2016. It should come as no surprise that the blue bars are in negative territory during most of the period. With the exceptions of 1999 and 2000, the federal government has run budget deficits. The red bars in the chart represent the aggregated net lending (+) or net borrowing (-) of households, nonfinancial businesses, state and local governments and the rest of the world. With two exceptions, 1979 and 2006, these combined sectors have been net lenders. Notice that the blue bars and red bars behave in a manner as though they are mirror images of each other. That is, as the federal government’s net borrowing increases in magnitude, i.e., the blue bars sink farther into negative territory, the combined nonfinancial sectors’ (excluding the federal government) net lending increases in magnitude, i.e., the red bars rise higher into positive territory. The two series are negatively correlated with absolute-value coefficient of 0.85. Recall that an absolute-value coefficient of 1.00 represents perfect correlation. The data in the chart support my argument that as the federal government dissaves (borrows) more, other sectors save (lend) more.

If the Fed and the banking system, combined, fund the wider federal government budget resulting from TCJA, then the tax cuts can stimulate private sector spending on goods and services. The Fed and the banking system have the ability to create credit figuratively out of thin air. If households and businesses increase their current spending on goods and services because of their increased after-tax income and the Fed and the banking system create the credit out of thin air to fund the wider federal budget deficit, then no other entity needs to cut its current spending. Under these circumstances, TCJA could produce an economic sugar high because the Fed and the banking system are providing the sugar.

What would motivate the Fed and the banking system to create the thin-air credit to fund the wider federal government budget deficit resulting from TCJA? All else the same, the wider federal budget deficit would represent a net increase in the aggregate demand for credit. When the demand for something increases, upward pressure on the price of that something is exerted. In this case, there would be upward pressure on the level of the structure of interest rates. If the Fed does not let the overnight federal funds rate drift upward with other interest rates, then banks will have an incentive to lend more (create more thin-air credit) because the spread between their loan rates and their marginal cost of funds will have widened. But the banking system will need more Fed-created reserves if bank loans and deposits in the aggregate increase. In order for the Fed to keep the federal funds rate from rising, it will have to create more cash reserves out of thin air.

Will the Fed and the banking system fund the wider federal government budget deficit? In the words of President Trump, “We’ll have to see about that.”  The Fed currently is in a rate-raising mode. Consumer inflation is picking up. Consumer spending growth has been strong. Labor markets are tighter than a snare drum. And thin-air credit growth picked up in Q4:2017, ironically, due to an acceleration in monetary base growth. I say “ironically” because monetary base growth, all else the same, would have been expected to slow as the Fed began to pare its securities holding in late 2017. Obviously, all else was not the same. The upshot is that the Fed in 2018 will be moving the level of the federal funds rate in the same direction that the TCJA-induced wider federal government budget deficit will be moving it. By sheer chance, then, the Fed is likely to limit the amount of thin-air credit funding of the wider budget deficit.

Paul L. Kasriel
Founder, Econtrarian LLC
Senior Economic and Investment Advisor
1-920-818-0236
“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte 

∆ + 6 = A Good Life

Send any comments to me at econtrarian@gmail.com.