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

Monday, May 5, 2014

The Media's Reporting of the April Unemployment Rate -- A Little Knowledge Can Be Dangerous

May 5, 2014

The Media’s Reporting of the April Unemployment Rate – A Little Knowledge Can Be Dangerous

Economists have “trained” the media to quickly check out what has happened to the labor force when the unemployment rate declines. If the unemployment rate drops and so, too, does the labor force, then the decline in the unemployment rate might not be a signal of a strengthening labor market. Rather, under these circumstances, the decline in the unemployment rate might reflect potential workers becoming discouraged over the lack of employment opportunities and, therefore, dropping out of the labor force. I emphasize “might” because a decline in the labor force does not always reflect an increase in so-called discouraged workers. And, in fact – well, fact may be too strong a word, but according to data contained in the April Household Employment Survey – the number of people not in the labor force in April but who did want a job changed by a big fat ZERO. But the mainstream media, financial or general, did not report this. Rather, they reported that the 0.4 point decline in the April unemployment rate was suspect because labor force dropped by 806 thousand, implying that thousands must have exited the labor force because of poor job prospects.

When the “highlights” of the monthly employment report are first reported on CNBC and Bloomberg TV, complete with the six frames of “experts”, and a report like April’s is released with a decline in both the unemployment rate and the labor force, the first thing I look at in Table A-1, Employment Status of the Civilian Population, of the Household Employment Survey is the line “Persons who currently want a job”, which is a subcategory of the line above it, “Not in the labor force”. As I mentioned in the preceding paragraph, the number of people who were not in the labor force in April but who also currently wanted a job changed by zero from March. So, although a one-month’s decline in the labor force of 806 thousand is, indeed, an anomaly, another datum obtained from the same survey indicates that this decline in the labor force was not due to potential workers dropping out because of poor job prospects.

The second thing I look at after a monthly employment report similar to April’s is released is Table A-15 in the Household Employment Survey, “Alternative Measures of Labor Underutilization”. Specifically, I look at the U-5 measure of measure of the unemployment rate, “Total Unemployed plus Marginally Attached Workers as a percent of the Civilian Labor Force plus All Marginally Attached Workers”. (Persons marginally attached to the labor force are those who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the past 12 months. Discouraged workers, a subset of the marginally attached, have
given a job-market related reason for not currently looking for work.) So, the U-5 unemployment rate definition accounts for those unemployed potential workers who currently desire a job but have stopped looking for employment. If the “headline” unemployment rate, technically, the U-3 definition in Table A-15, declines and the U-5 unemployment rate declines by a similar magnitude, then one can deduce that the decline in the headline unemployment rate was not due to potential workers dropping out of the labor force because of a lack of employment opportunities.

The chart below shows the month-to-month change in the labor force along with the month-to-month changes in the headline unemployment rate and the U-5 definition of the unemployment rate. In April, the 806 thousand person decline in the labor force was accompanied by a 0.4 point decline in both the headline and U-5 unemployment rates. Because the U-5 unemployment rate includes those who have dropped out of the labor force but who currently do desire to work and because this measure of the unemployment rate declined by the same magnitude as the headline measure, we cannot infer that the 0.4 decline in the headline unemployment rate was somehow “tainted” by people dropping out of the labor force due to bleak job prospects, as many in the media did infer.



In December 2013, the labor force dropped by 347 thousand, accompanied by a 0.3 decline in the headline unemployment rate and only a 0.1 point decline in the U-5 unemployment rate. Thus, in December 2013 in contrast to April 2014, I would surmise that part of the decline in the headline unemployment rate was related to people who wanted to work dropping out of the labor force in December.

 In the 12 months ended April 2014, there has been a 0.5 point net decline in the labor participation rate, the civilian labor force as a percent of the civilian noninstitutional population. In these same 12 months, there has been a 1.2 point net decline in the headline unemployment rate. Given the decline in the participation rate, a statistic that the media has been trained to focus on when interpreting a decline in the headline unemployment rate, can we conclude that the decline in the headline unemployment rate overstates the improvement in labor market conditions because potential workers are choosing not to “participate” in the hunt for jobs due to weak job prospects? No, because in these same 12 months there has been a 1.3 point decline in the U-5 unemployment rate, which accounts for labor force dropouts due to weak job prospects.


It remains a mystery as to why in April the labor force plunged by 806 thousand and why the labor participation rate fell by 0.4 points. Looking at changes in the participation rate by age categories, it is revealed that the largest April declines were concentrated in the 16-to-24 year old cohort. Perhaps a light when on in the brains of our youth, alerting them to the value of education and inducing them to stay in or go back to school. I don’t know. But what I do know from the data in other parts of the Household Employment Situation Survey is that the bulk of the declines in the April labor force and participation rate was not due to people suddenly deciding to sit on their couches and eat Cheetos all day because job prospects were so bleak in April.


Perhaps I am being too critical of the media for not being more diligent in analyzing the monthly employment data. After all, I do not recall any economist interviewed by the mainstream media mentioning that the U-5 unemployment rate also fell by 0.4 points in April, thereby ruling out the notion that the headline unemployment rate fell because workers dropped out of the labor force because they were so disheartened by weak job prospects. If the “experts” the media turn to for analysis do not examine and/or understand the relevant sections of the employment reports, how can I really expect the media to accurately report the economic news?

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

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