Tuesday, March 8, 2016

NIRP -- No Need to Go There

March 8, 2016
NIRP – No Need to Go There

A new acronym has entered the lexicon of central banking in recent months – NIRP, which stands for negative interest rate policy. If ZIRP, zero interest rate policy, won’t stimulate faster growth in nominal spending and/or faster growth in the prices of goods and services, then perhaps central bank-engineered negative short-term interest rates will do the trick. In June 2014, the European Central Bank (ECB) introduced NIRP and the central banks of Switzerland, Denmark, Sweden, and Japan have recently done so as well. For the most part, NIRP involves a central bank paying a negative rate of interest on a portion of reserves or deposits held by private depository institutions (mainly commercial banks) at the central banks. One purpose of NIRP is to encourage banks to make more loans by penalizing them with a negative nominal return on “excess” reserves held at the central bank. Another purpose of NIRP is to achieve a lower structure of real (inflation-expectations adjusted) interest rates. After all, if the yields on short-maturity interest rates are at zero and investors expect deflation, then the real yields on these securities would be positive. (The real yield is the nominal yield minus inflation expectations. If the nominal yield is zero and inflation expectations are negative, i.e., deflation is expected, then zero minus a negative number results in a positive number.) If nominal aggregate demand is growing at a sub-optimal rate, then a lower structure of real interest rates would likely cause the quantity of bank credit demanded to increase, which if the credit were granted would, in turn, cause growth in aggregate demand to increase. NIRP is a remedy for insufficient demand for bank credit.

But if growth in nominal aggregate demand is sub-optimal because of an insufficient supply of bank credit, then NIRP will not be effective in remedying the situation. If banks do not have the capital to support their acquisition of more loans and securities with credit and/or interest rate risk, then charging these banks a “storage fee” for reserves held at the central bank will not induce them to create more credit. It will do the opposite. The extra expense charged banks by the central bank for reserves storage will reduce bank profits, inhibiting growth in the bank capital necessary to allow banks to increase their acquisitions of loans and securities.

The remedy for an insufficient supply of bank credit is an increased supply of a close substitute, central bank credit. This is what the central bank policy of quantitative easing (QE) is all about – providing an increased supply of central bank credit to supplement an insufficient supply of bank credit due to banks’ inadequate capital.  The “gas” that inflates an asset-price bubble is credit. When the asset-price bubble bursts and asset prices deflate, the lenders who were providing the bubble-inflating credit suffer losses, which depletes their capital. If banks have provided significant amounts of the bubble-inflating credit, either directly or indirectly, then when the bubble bursts they will suffer losses that could inhibit their ability to extend new credit. What’s more, typically after an asset-price bubble has burst, the financial regulators impose higher capital requirements explicitly and implicitly on banks. If banks are capital constrained and central banks do not pursue an effective QE policy, growth in nominal aggregate demand will remain anemic.

Let’s go to the charts. Plotted in Chart 1 are quarterly observations of total financial assets minus reserves held at the central bank (primarily loans and securities) for private depository institutions in the US and the Euro area. I have converted each series to an index number (with the Q4:2008 levels equal to 100) for ease of comparison.  For US private depository institutions, non-reserves assets did not return to their Q4:2008 level until Q4:2013. But by Q3:2015, these assets on the books of US private depository institutions were at an index level of 110.7 or 10.7% above their Q4:2008 level. Initially, non-reserves assets at Euro-area private depository institutions increased until the end of 2011. After declining through the end of 2013, then rebounding in 2014, non-reserves assets at Euro-area private depository institutions stood at a level only 0.1% higher than they were in Q4:2008. In sum, over this almost 7-year period, non-reserves financial assets at US private depository institutions grew at a compound annual rate of just 1.5% while these assets at Euro-area private depository institutions, for all intents and purposes, showed no growth, on net.
Chart 1

Now let’s see what the Fed and the ECB did to augment the anemic amount of credit created in this period by private depository institutions. Plotted in Chart 2 are the index levels of the sum of Fed financial assets plus US private depository institution financial assets less reserves at the Fed. Let’s call this sum, total thin-air credit.  (Everyone may now knock back a shot.) Also plotted in Chart 2 are the index levels of non-reserves financial assets at US private depository institutions. Wow! What a difference a central bank can make in creating thin-air credit to compensate for weak credit creation on the part of private depository institutions. By Q3:2015, total US thin-air credit stood 36.3% above its Q4:2008 level, representing a compound annual rate of growth of 4.7%. Although 4.7% pales in comparison to the 7.6% compound annual growth in total thin-air credit in the 55 years ended 2007, it still is a heck of a lot stronger than the 1.5% compound annual growth in credit created by US private depository institutions alone from Q4:2008 through Q3:2015.
Chart 2
Now let’s look at these data for the Euro-area. Plotted in Chart 3 are the index levels of the sum of ECB financial assets plus Euro-area private depository institution financial assets less reserves at the ECB or total Euro-area thin-air credit. Also plotted in Chart 3 are the index levels of non-reserves financial assets at Euro-area private depository institutions. This chart contains data through Q4:2015 whereas data in previous charts ran only through Q3:2015. The reason for this difference is that the ECB has released Q4:2015 data while the Fed will not do so until March 10. Taking into consideration Q4:2015 data, Euro-area total thin-air credit grew at a compound annual rate of only 0.7% from Q4:2008. But if the ECB had not provided thin-air credit via various lending facilities to depository institutions and belatedly via QE, the change in Euro-area thin-air credit would have been even more anemic. When Q4:2015 is included, credit provided by Euro-area private depository institutions actually contracted, on net, vs. Q4:2008.The conclusion is that the ECB was late coming to the QE party and brought too little party “punch”.
Chart 3
So, let’s review. In the seven years following the global financial crisis of 2008, credit created by private depository institutions in both the US and the Euro-area, on net, has been anemic, if at all. Immediately after the crisis, the Fed created massive amounts of temporary credit to the US private depository institution system as well as non-depository financial institutions via loans. Soon thereafter, the Fed engaged in three separate rounds of QE that resulted in net Fed purchases of securities of $3.7 trillion in the 24 quarters ended Q4:2014. In contrast, the ECB has engaged in only one round of QE, which commenced in Q4:2014. In the five quarters ended Q4:2015, the net change in securities on the books of the ECB was only about $631 billion at current exchange rates. So, the Fed’s QE operations started earlier than the ECB’s, persisted on and off for a six-year period, and were cumulatively much larger.

Now, let’s see which economy has experienced faster growth in nominal domestic demand. This is shown in Chart 4 where the index values of Gross Domestic Purchases for the US and the Euro-area are plotted. In the 28 quarters from Q4:2008 through Q3:2015, Euro-area nominal Gross Domestic Purchases increased at a compound annual rate of just 0.9%. In the 28 quarters from Q4:2008 through Q4:2015, US Gross Domestic Purchases increased at a compound annual rate of 3.0%.

Chart 4
The ECB will have a monetary policy meeting on March 10. It is likely that a more aggressive NIRP will be discussed. If the goal of the ECB is to stimulate growth in nominal domestic demand, it should not waste its time considering or implanting NIRP. Rather, go with what has “worked” for the Fed. The ECB should pursue an aggressive and persistent QE policy such that the sum of ECB credit and Euro-area private depository institution credit grows at some “normal” rate. Despite the success of QE by the Fed in stimulating growth in US nominal domestic demand, many a talking twerp is discussing the necessity of NIRP to bring the US economy out of its next recession. First, why worry about the next US recession when there is none on the horizon? Second, if QE worked to help get the US economy out of its worst recession since the early 1930s, why don’t you think it will work in producing a recovery from the next US recession, whenever it may come?

Note: On the off chance that you have questions or comments to which you desire my reply, please email me directly. You, of course, are free to post comments or questions on my blog page and/or on my LinkedIn page. However, I seldom visit these pages except to post a new commentary.

Paul L. Kasriel
Senior Economic and Investment Advisor
Legacy Private Trust Co. of Neenah, WI
Founder and Six Sigma Director of Econtrarian, LLC

1-920-559-0375

Monday, January 25, 2016

To Quote Aaron Rodgers -- R-E-L-A-X

January 25, 2016

To Quote Aaron Rodgers  --  R-E-L-A-X

Yes, Q4-2015 real GDP growth likely slowed to a crawl. Yes, the stock market has taken it on the chin in recent weeks. Yes, credit-quality yield spreads have been trending higher since mid-year 2015. Yes, commodity prices have cratered. Is it time to panic about an impending U.S. economic recession? Investors would be wise to heed the advice given to anxious Green Bay Packers’ football fans after the Pack’s 1-2 start to the 2014 regular season by future NFL Hall of Fame quarterback, Aaron Rodgers,
“R-E-L-A-X.”  (Rodgers’ advice was prescient. The Pack went on to post a 12-4 regular season record, losing a heartbreaker in overtime to the Seattle Seahawks in the NFC championship playoff game.) After a shaky start in 2016, U.S. risk assets may not perform as well as the Packers did in 2014 after their shaky start. But, I believe that the U.S. economy and risk assets can still post a “winning season” in 2016. Just as the performance of Aaron Rodgers helped turnaround the Pack’s 2014 season, the likely performance of thin-air credit will help turnaround U.S. economy’s 2016 season.

Back on December 1, 2015, I penned a piece entitled “The December 16th Fed Tightening – Preemptive to a Fault” in which I argued that the Fed’s imminent December 16 rate hike would come in the face of a significant slowing in the growth of U.S. economic activity, low and declining inflation, save for house prices, and low inflation expectations based on market indicators (rather than Fed economists’ forecasts). I stand by my December 1 commentary. On Friday, January 29, the Bureau of Economic Analysis is scheduled to release its advance (first of many) estimate of Q4:2015 real GDP annualized growth. The Federal Reserve Bank of Atlanta’s GDPNow estimate of it as of January 20 was 0.7%. The consensus estimate of it from economists participating in the Bloomberg survey is 0.9%. To refresh your memory, real GDP grew at an annualized pace of only 2.0% in Q3:2015. So, the pace of U.S. economic activity likely slowed further in Q4:2015 from an already tepid pace in the previous quarter. No matter how you slice it or dice it, neither is current goods/services price inflation above the Fed’s 2% target nor do market-based expectations suggest it is likely to rise above the Fed’s target anytime soon (see Charts 1 and 2).
Chart 1


Chart 2

In my December 1, 2015 commentary, not only did I argue that the Fed’s imminent interest rate increase was ill advised, but that it would necessitate a reduction in Fed-created depository institution reserves, which would adversely affect the growth of total thin-air credit, i.e., the sum of credit created by depository institutions and the credit created by the Fed (depository institution reserves). Chart 3 shows that the monthly average of total depository institution reserves fell (by $179 billion) in December 2015 as the Fed implemented a 25 b.p. increase in its target federal funds rate mid month.
Chart 3
And sure enough, growth in total thin-air credit was adversely affected. As shown in Chart 4, total thin-air credit contracted at an annualized rate of about 4-1/2% in December 2015 compared to the previous month’s annualized growth of 4.7%. On a three-month annualized basis, total thin-air credit growth slowed to 3.0% in December 2015 vs. 7.2% in November 2015. The long-run median growth in total thin-air credit is around 7-1/4%.




Chart 4
With this contraction or slowing in the growth of total thin-air credit, depending on the time period considered, why am I confident that a U.S. recession is not imminent and that the pace of economic activity will pick up in 2016 from its Q4:2015 slowing? There are two reasons for my relatively optimistic outlook. First, although the Fed’s contribution to thin-air credit took a nosedive in December 2015, the commercial banking system’s contribution to thin-air credit has been robust in recent months and weeks. Second, after its December 16, 2015 interest rate increase faux pas, the Fed will be slow to increase its policy interest rates again in 2016. In turn, this implies that the Fed will not need to reduce again soon its contribution to thin-air credit, i.e., reserves.

Chart 5 shows clearly why total thin-air credit contracted month-to-month in December 2015. It was because of the contraction in depository institution reserves at the Fed. Reserves contracted at an annualized rate of 51.4% in December 2015 vs. the month prior, while commercial bank credit grew at an annualized rate of 9.1%.
Chart 5

Weekly observations of commercial bank credit show that this component of thin-air credit continues to grow robustly on a year-over-year basis as well as an 8-week basis (see Chart 6). So, if the Fed’s contribution to thin-air credit, bank reserves, would stop contracting, total thin-air credit growth would likely re-accelerate.
Chart 6
And that’s exactly what has happened. Chart 7 shows that on a weekly basis bank reserves fell throughout the month of December 2015 in order to effect the rise in the Fed’s federal funds rate target. But the level of bank reserves has moved higher in the first three weeks of January 2016. Keep in mind, the Fed would need to lower the supply of reserves relative to the demand for reserves if the federal funds rate is to be increased. But once that higher federal funds rate level has been achieved, the Fed does not have to continue reducing the supply of reserves to maintain the higher federal funds rate level, all else the same.  So, if the Fed’s December 2015 interest rate hike will not be repeated for some time, the level of bank reserves would not be expected to decline further other than for temporary seasonal reasons.
Chart 7


Again, if bank credit growth were to continue at its recent robust pace and bank reserves were to just stop contracting, which appears to be the case, then total thin-air credit would be expected to re-accelerate going forward. Although four weeks do not exactly a trend make and using weekly reserves data that are not seasonally adjusted is not best practice, growth in total thin-air credit has begun to re-accelerate in January 2016, as shown in Chart 8.
Chart 8
In sum, despite U.S. economic growth slowing to almost stall speed in Q4:2015, the U.S. economy is unlikely to crash anytime soon. Although the Fed is unlikely to reverse its ill-advised December 2015 interest rate increase, it also is unlikely to again raise interest rates and contract reserves until it is sure U.S. real economic growth is back on a sustained 2-1/2%+ trajectory and there are at least some faint signs of inflationary pressures. In my view, the earliest these conditions would be met and known is mid 2016. Bear in mind, the Fed has stated that its monetary policy is data dependent. If the economic data don’t spike, the FOMC won’t hike. So, my advice to U.S. investors is what was Aaron Rodgers’ advice to Packers’ fans early in the 2014 NFL regular season – R-E-L-A-X. The U.S. economy and the prices of U.S. risk assets are likely to turn up later in 2016 as thin-air credit growth re-accelerates.



On a sad note, Robert G. Dederick, retired chief economist of The Northern Trust Company, passed away on January 19, 2016. Bob invited me to join his economic research staff in August 1986 and was my boss until his retirement in November 1994. No one could glean the nuances of an economic report better than Bob. Although Bob and I had our theoretical differences, I am indebted to him for giving me the opportunity to join his staff and grow professionally. May you rest in peace, Bob. You have earned it.

Paul L. Kasriel
Senior Economic and Investment Advisor
Legacy Private Trust Co. of Neenah, WI
Founder and Director of Total Quality Management, Econtrarian, LLC
1-920-818-0236




Tuesday, December 22, 2015

The 2015 Festivus Airing of Grievances

Embargoed until 5 PM CST, December 23, 2015

The 2015 Festivus Airing of Grievances

Well, it’s that time of the year again for the airing of grievances.  And, although I don’t have a lot of problems with you people this year, rest assured, I have a few. The first one has to do with the continued misconception that the purpose and measure of effectiveness of central bank quantitative easing (QE) is related to a decline in bond yields. If falling bond yields are an indicator of an easing monetary policy, then how would one explain the contractions in industrial production almost month after month from October 1929 through June 1931 in the face of declining bond yields (see Chart 1)?
Chart 1
Let’s fast forward to recent years when the Fed was engaged in three separate rounds of QE. As shown in Chart 2, generally, as the Fed stepped up its purchases of securities in the open market, bond yields tended to move higher. Conversely, as the Fed backed off its securities purchases, bond yields tended to move lower. So according to conventional wisdom (?), the Fed’s QE was a failure because the level of  bond yields was positively correlated with the amounts of securities purchased rather than negatively correlated, as the cognoscenti hypothesized.
Chart 2

Okay, when the Fed stepped up its securities purchases, the level of bond yields tended to rise. Does this imply that QE was a failed policy with regard to its ultimate purpose – to stimulate the growth in domestic aggregate demand? On the contrary, QE was successful in stimulating nominal aggregate demand (and real aggregate demand, too). QE provided thin-air credit to the economy, augmenting that provided by private depository institutions. (Alright, you may drink from your Festivus wassail cup now that I have mentioned thin-air credit.) Let’s compare the relationship between year-over-year growth in nominal gross domestic purchases with the year-over-year growth in thin-air credit provided by private depository institutions and then thin-air credit growth augmented by Fed securities purchases. These relationships along with correlation coefficients are shown in Charts 3 and 4.
Chart 3
Chart 4
When Fed securities purchases are excluded, the correlation between growth in private depository institution thin-air credit, advanced one quarter,  and growth in nominal domestic aggregate demand is 0.25. When Fed securities purchases are added to private depository institution thin-air credit, the correlation between growth in this Fed-augmented thin-air credit, advanced one quarter, and growth in nominal domestic aggregate demand more than doubles to 0.55. So, if the goal of a monetary policy is to push bond yields lower, it would seem that the Fed should sell large quantities of securities. Notice that on December 17 and December 18, 2015, when the Fed began implementing its policy interest rate increase by draining reserves (thin-air credit), Treasury bond yields fell. If the goal of a monetary policy is to stimulate nominal domestic aggregate demand, then it would seem that the Fed should purchase large quantities of securities.

Another problem I have with you people (i.e., mainstream economists) is your proclivity to strip out telling elements of an economic report. What I have in mind here is the monthly retail sales report. First, you strip out new car and truck sales because the Commerce Department uses a separate unit sales report when it calculates the contribution of car and truck sales to personal consumption expenditures. Fair enough. Then why don’t you add back into nominal retail sales excluding autos your estimate of motor vehicle sales from the unit sales report that had been released previously?  I mean if I am interested in the behavior of total household spending on goods, leaving out spending on motor vehicles provides only a partial picture. By the way, the correlation between month-to-month percent changes in nominal retail sales of new cars and trucks and unit sales of new cars and trucks is pretty high, at 0.90, as shown in Chart 5.
Chart 5
And then there is the convention to exclude from retail sales those for building materials and garden equipment. The rationale is that this category gets captured in the residential investment (housing) component of GDP. Alright. But expenditures on building materials are part of total spending in the economy. If you are stripping these expenditures out of retail sales, please tell me by how much they raise or lower your residential investment estimate. Enquiring minds want to know (as in National Enquirer, you twit who scolded me for not spelling it “inquiring”).

But what really steams me is the exclusion of gasoline sales from retail sales. Yes, gasoline sales are volatile month-to-month because of volatile gasoline prices. The short-run demand for the physical volume of gasoline is relatively insensitive to variations in its price. I need X gallons of gasoline to get to and from work each week. So, a 10 cents or 20 cents change in the price of a gallon of gasoline in a month is not going to change that much the number of gallons I purchase that month.

But, assume that the price of gasoline is trending lower over a number of months. All else the same, would I not use the income previously spent on gasoline purchases to increase my purchases of more discretionary items? Alternatively, observing a more persistent decline in gasoline prices, I might increase my discretionary driving, which would entail an increase in the volume of gasoline I purchase. Either way, on a longer-term basis, growth in my nominal retail expenditures should not be negatively affected by lower trending gasoline prices. I use the “savings” from lower gasoline prices to step up my nominal and real spending on more discretionary items. But if gasoline sales are stripped out of total retail sales, this information is lost.

Let’s see what has happened in the past 12 months to gasoline prices, total retail sales and retail sales excluding gasoline sales. The year-over-year percent changes in each of these series are shown in Chart 6.
Chart 6

In the 12 months ended November 2015, the price of a gallon of unleaded regular gasoline has fallen 36.3%. In this same period, total nominal retail sales have increased 1.4%. This compares with an increase of 4.9% in the 12 months ended November 2014. So, growth in total nominal retail sales has slowed sharply in 2015 vs. 2014. With their “savings” from lower gasoline prices, why didn’t households increase their spending on discretionary items? Even if nominal gasoline sales are excluded from nominal retail sales, there still has been slowdown in the growth household spending on goods. In the 12 months ended November 2015, retail sales excluding gasoline sales increased by 3.7%, down from the 5.9% increase in the 12 months ended November 2014.

What’s been going on here? One thing that has been going on is that households have been using some of their gasoline “savings” to build up their liquidity in the form of currency and deposits at banks and other depository institutions. This is implied in Chart 7. In the four quarters ended Q3:2015, household acquisitions of currency and deposits relative to their after-tax income averaged 4.6% vs. 3.9% in the four quarters ended Q3:2014. In economics jargon, this means that the velocity of money has fallen. Falling money velocity implies slower growth in nominal spending.
Chart 7
An explanation of how a decline in the velocity of money results in weaker nominal spending will have to wait for another time. Right now, it’s time to 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 chests.
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, Founder and Head of Values (BBC “W1A”)
Senior Economic and Investment Advisor
Legacy Private Trust Co. of Neenah, WI
1-920-818-0236