Tuesday, July 14, 2015

If the Fed Raises Policy Interest Rates in 2015, It's Likely to Be One and Done

July 14, 2015

If the Fed Raises Policy Interest Rates in 2015, It’s Likely to Be One and Done

Last week, Fed Chairperson Yellen indicated that the Fed was likely to raise its policy interest rates sometime before year end. Given the behavior of the sum of commercial bank credit and depository institution reserves at the Fed in the past three quarters, it is a mystery to me why the Fed would be contemplating a policy interest rate increase at this juncture. But if this is something the Fed just has to get out of its system, then the first increase is unlikely to be followed by a second interest rate increase for some time.

To briefly review my focus on the sum of commercial bank credit and reserves at the Fed , because depository institutions (commercial banks, savings institutions and credit unions) are required to hold only a fraction of the amount of their deposits as reserves at the Fed, they are able to create credit by an amount that is a multiple of their reserves. This credit is figuratively created out of thin air. The reserves that depository institutions hold at the Fed are, in fact, created by the Fed. When an asset item on the Fed’s balance sheet increases, say a Fed purchase of securities, a liability item on the Fed’s balance sheet also increases. One liability item on the Fed’s balance sheet is reserves owed to depository institutions. So, these reserves, which serve as the “seed money” for the credit created by depository institutions, also are figuratively created out of thin air.

Entities typically borrow in order to purchase something – a good, a service, a financial instrument. When the credit that is financing purchases is created out of thin air, net spending in the economy increases as the borrowers increase their spending and no one else cuts back on his/her spending. In contrast, when the credit that is financing purchases emanates from new saving, then the change in net spending in the economy is zero. Saving is the act of curbing one’s current spending and transferring this purchasing power to a borrower. So, the borrower increases his/her current spending and the saver decreases his/her current spending.

Plotted in Chart 1 are the year-to-year percent changes in the sum of depository institution credit and reserves held at the Fed along with the year-to-year percent changes in nominal Gross Domestic Purchases. Gross Domestic Purchases are expenditures by U.S. households, businesses and government entities on newly-produced goods and services. So, expenditures on imported goods and services are included in Gross Domestic Purchases while expenditures by foreign entities on U.S.-produced exports of goods and services are excluded. From 1953 through 2014, the contemporaneous correlation between percent changes in thin-air credit and percent changes in Gross Domestic Purchases is 0.59 out of a maximum possible 1.00. Gross Domestic Purchases does not include the value of used products purchased (e.g., used cars and existing homes) and does not include the value of financial instruments purchased. If a measure existed that added these excluded items to Gross Domestic Purchases, it is likely that the correlation between its changes and changes in thin-air credit would be even higher than 0.59.









Chart 1

So, now you know why I am obsessed with thin-air credit with respect to monetary policy. The behavior of thin-air credit plays an important role in behavior of nominal spending in the economy. If the growth in thin-air credit is rapid, the risk of the economy overheating and/or the formation of asset-price bubbles would be heightened. If growth in thin-air credit were rapid, increases in Fed policy interest rates would be entirely appropriate in order to prevent a rise in the inflation rate of goods/services and/or asset prices.

But, as shown in Chart 2, growth in a subset of total thin-air credit, the sum of commercial bank credit and reserves at the Fed, has been decelerating in recent quarters and is below its long-run median growth rate. Chart 2 contains growth rates in the sum of commercial bank credit and reserves at the Fed. Commercial bank credit accounts for over 80% of total depository institution credit. The Fed reports commercial bank credit weekly with a one-week lag, whereas it reports total depository institution credit only quarterly with about a one-quarter lag. The long-run median growth rate in the sum of commercial bank credit and reserves at the Fed is 7.1%. As shown in Chart 2, growth in the sum of commercial bank credit and reserves at the Fed was 6.0% in Q2:2015 vs. Q2:2014. Moreover, the growth in the sum of commercial bank credit and reserves at the Fed has been trending decidedly slower starting in Q4:2014, when the Fed terminated its QE program. Quarter-to-quarter annualized growth in the sum of commercial bank credit and reserves at the Fed slipped to 5.1% in Q2:2015 and its trend growth has been decelerating since Q4:2013. This current below “normal” growth in the largest component of thin-air credit implies that the dangers of a near-term overheated economic environment and/or inflation of an asset-price bubble are low.


Chart 2

The principal factor accounting for the recent slowing in the growth of thin-air credit is the Fed’s contribution, reserves at the Fed. This is shown in Chart 3, in which 3-month point-to-point annualized growth rates are plotted instead of growth rates of quarterly averages. Starting in November 2014, the month after the Fed’s QE program ended, the three-month annualized percent changes in reserves at the Fed, with two exceptions, have been in negative territory. That is, since the end of QE, reserves at the Fed have contracted on net. But the bank-credit component of thin-air credit also has demonstrated a slowing growth trend. After surging in the three months ended January 2015 at an annualized growth rate of 10%, growth in commercial bank credit slowed to a below “normal’ rate of 6.5% in the three months ended June 2015.







Chart 3

Again, the current behavior of thin-air credit does not portend an acceleration in the rate of price increases for goods/services or assets. And the recent behavior of these price changes would not seem to warrant concern by the Fed. Consumer price inflation, as represented by the Personal Consumption Expenditure price index, remains tame. In the three months ended May 2015, this measure of consumer price inflation had increased at an annualized rate of 2.2%, recovering from the price declines earlier in the year due to falling energy prices (see Chart 4). Commodity prices of all stripes have been trending lower in recent months, as shown in Chart 5. And asset prices are not racing to the moon (See Chart 6).













Chart 4
Chart 5

Chart 6
So, current inflationary pressures are quite mild here in the U.S. The current rate of growth in U.S. thin-air credit is below its “normal” rate, suggesting that credit creation is not fostering a future surge in U.S. inflation. And the global inflationary environment appears equally tranquil, if not more so. The Chinese economy, which already had experienced a growth slowdown, will now be negatively affected by its recent stock market swoon. And Europe is not exactly booming, Greece aside. Given all this, it is not clear what is motivating the Fed’s desire to raise its policy interest rates sometime later this year. Whatever the motivation, if the Fed does pull the interest-rate tightening trigger in 2015, it will not likely do so again for many months thereafter. In other words, for Fed interest rate hikes in 2015, it’s one and done.

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



Monday, July 6, 2015

The June Unemployment Rate Fell to 5.3%, but ...

July 6, 2015

The June Unemployment Rate Fell to 5.3%, but …

It seems as though there usually is a “but” when the unemployment rate falls by more than expected by the cognoscenti. The consensus estimate for the June unemployment rate was 5.4%, down from May’s 5.5%. Instead, the BLS reported that the June unemployment rate fell to 5.3%, its lowest reading since April 2008. Might this be cause for celebration if one were not an economic masochist? Au contraire, according to the mainstream media talking heads.  After reporting the larger-than-expected decline in the June unemployment rate, the talking heads quickly inserted the “but” – but the labor force participation rate fell three-tenths of a point to 62.6%, its lowest since October 1977. The simultaneous decline in the unemployment rate and the labor force participation rate is consistent with the notion that the unemployment fell because people dropped out of the labor force due to discouragement over poor job prospects. So, recork the champagne, right? Wrong.
Before getting too deep into this, let’s define some terms. The “headline” or U-3 unemployment rate is the ratio of the number of people who are unemployed to the civilian labor force. Of course these numbers are estimates “blown up” from responses solicited from a relatively small sample of households. To be considered unemployed, one has to have been available to work if the opportunity to do so had arisen and have actively sought employment. The labor force is defined as the sum of people 16 years old or older who are employed or are unemployed (unemployed, i.e., according to the definition given above).

Let’s run through a couple of numerical examples of how the unemployment rate might fall. Let’s assume that the total number of “officially” unemployed is 5 million and the labor force is 100 million. In this case the unemployment rate would be 5% (5/100 x 100). Now let’s assume that the number of unemployed falls by 1 million to a total of 4 million and the labor force increases by 1 million to a total of 101 million. In this case, the unemployment rate falls to 4%, rounded. Alternatively, suppose that the number of unemployed again declines by 1 million to a total of 4 million and the labor force also declines by 1 million to a total of 99 million. Lo and behold, the unemployment rate again falls to 4%, rounded. By the laws of arithmetic, if both the number of unemployed and the number of the civilian labor force decline, the unemployment rate also will decline if the percentage decline in the number of unemployed is greater than the percentage decline in the number of the civilian labor force. And, arithmetically speaking, this is what occurred in June. The number of unemployed fell by 375 thousand or by 4.3% as the civilian labor force fell by 432 thousand or by 0.3%, resulting in a decline in the unemployment rate of two-tenths of a percent.

The question arises as to whether the drop in the number of unemployed was related to the drop in the labor force. For example, did 375 thousand people who in May were classified as unemployed become discouraged with their job prospects and throw in the towel with respect to seeking employment. If so, these people would no longer be categorized as unemployed if they had stopped looking for a job. And if these 375 thousand people were no longer looking for a job, they would no longer be counted in the civilian labor force. Thus, the labor force number would drop, too. This decline in the June number of unemployed and the labor force being due to discouragement of job prospects is just an hypothesis. We cannot make this determination simply by observing the simultaneous declines in both the number of unemployed and the labor force.

When a decline in the unemployment rate is accompanied by a decline in both the number of unemployed and the labor force, media talking heads look to the participation rate for clarification as to why the unemployment rate fell. For the life of me, I do not know why they look to the participation rate for clarification, but they do. The labor force participation rate is defined as the number of people in the civilian labor force (i.e., the sum of the number of employed and unemployed) as a percent of the population 16 years old and older, or the “potential” labor force. All else the same, then, a decline in the labor force would result in a decline in the labor force participation rate. As I noted above, in June, the labor force participation rate declined by three-tenths of a percent to decades low of 62.6%. But this does not tell us why the labor force dipped in June. Perhaps people became discouraged with their job prospects and dropped out of the labor force. Perhaps not. Perhaps people dropped out of the labor force because they retired. Perhaps they went back to school. Perhaps they dropped out of the “official” labor force to perform the most important of jobs, rearing a newborn child. So, the behavior of the labor force participation rate does not provide us with much “color” regarding the behavior of the headline unemployment rate. A decline in the unemployment rate and a decline in the labor participation rate are necessary conditions for an explanation of the decline in the unemployment rate being related to people dropping out of the labor force because of discouragement due to poor job prospects. But they are not sufficient conditions. In other words, more information is required to make such a judgment.


The critical information regarding the sufficient conditions is contained in Table A-1, “Employment Status of the Civilian Population by Sex and Age”, of the Household Survey section of the Monthly Employment Situation. Line item 8 in this table is [number of people] “Not in labor force”. Line item 9 in this table is [number of] “Persons who currently want a job”. If the principal reason people are dropping out of the labor force is discouragement over job prospects, then we ought to see approximately equal increases in the number of people not in the labor force and the number of those people not in the labor force expressing an interest in obtaining employment. Chart 1 shows the month-to-month changes in the number of people not in the labor force and the number of these people desiring a job.
Chart 1
In June, the number of people not in the labor force increased by 640 thousand. Of that 640 thousand, there was only an increase of 18 thousand that desired a job now. This does not comport with the hypothesis that the decline in the June unemployment rate was the result of people dropping out of the labor force because of discouragement over job prospects.

But wait. There’s more. There’s Table A-15, “Alternative Measures of Labor Underutilization”, in the Household Survey section of the Monthly Employment Situation. One of the measures of labor underutilization is the U-5 unemployment rate which takes into consideration not only the “officially” unemployed but those unemployed categorized as “marginally attached” to the labor force.  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 are included in this category of marginally attached workers. If the headline unemployment rate (the U-3 measure of labor underutilization) and the participation rate were falling primarily because people were dropping out of the labor force out of discouragement, then the U-5 measure of labor underutilization, which takes into consideration discouraged workers and others who are only marginally attached to the labor force, would not decline and might even increase.  Chart 2 shows the month-to-month changes in both the U-3 (headline) and U-5 measures of the unemployment rate. In June, both the U-3 and U-5 measures declined by two-tenths of a percentage point, suggesting that job discouragement did not account for the decline in the headline unemployment rate.
Chart 2




I don’t know why the media talking heads do not look at line items 8 & 9 in Table A-1 and at Table A-15 in the Monthly Employment Situation report. Perhaps it is because they look only at the BLS press release, which does not include these items. I place little weight on the Monthly Employment Situation in assessing the current state of the U.S. economy. The data are based on samples, not universes. The data get revised many times over. But the media talking heads ought not to compound errors by ignoring relevant information in the report bearing on their hypotheses.

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

1 920 818 0236

Monday, June 1, 2015

Those Were the Days, My Friend

June 1, 2015

“Those Were the Days, My Friend
We Thought They’d Never End”
                                      Gene Raskin

As shown in Chart 1, 23 quarters after the 2009:Q2 business-cycle trough, real GDP growth has been the weakest of any 23-quarter post-cycle trough starting with that of 1961:Q2. Although I believe that the nature of the cause of the last recession, a financial crisis, is the principal factor accounting for the relative weakness of the current economic expansion, I also believe that the trend rate of growth of U.S. real GDP in the decades to come will be less than that in the preceding decades. The primary reason for this is related to demographics. A secondary reason is that the credit excesses that preceded the last recession will not be allowed to occur again for some time.
Chart 1


Let’s look at some of the excesses that existed before the onset of the last recession. By the way, these excesses were observable in the years leading up to the recession and financial crisis if anyone was curious enough to look at them. But, those were the days, my friend, and some thought they would never end (Alan?). First, note what was happening to household nominal spending on newly-produced goods/services and residential structures compared to household after-tax income. This is shown in Chart 2.

Chart 2
In 2004, for the first time in the post-WWII era, the sum of nominal personal consumption expenditures and residential investment (new home construction, home improvements and real estate brokerage commissions) reached 100% of disposable personal income. In 2005 and 2006, this measure of total household spending exceeded household after-tax income. Again, this post-war anomaly was clearly observable at the time it was occurring.

There are only two ways households can spend more than they earn – liquidate assets and/or borrow. Households chose to fund their “excess” spending by borrowing, as shown in Chart 3. From 1952 through 2002, the change in household liabilities (household borrowing) relative to disposable personal income had a median value of 5.9% and registered a maximum value of 10.8% in 1985. But starting in 2003 and continuing through 2006, household borrowing relative to after-income exceeded 12%.










Chart 3

In the post-war era, households have relied on home mortgages as their principal source of borrowed funds. In the years leading up to the last recession and financial crisis, households increased their reliance on home mortgages, including home-equity lines of credit, to fund their “excess” spending.
Chart 4

Enquiring minds might have wanted to know how housing values in the years leading up to the financial crisis could be maintained or continue to rise given their relationship to household income. After all, housing was the collateral backing a large part of the surge in loans to households. But those were the days, my friend and some thought they would never end. Chart 5 shows the market value of residential real estate relative to disposable personal income. From 1952 through 1989, the value of residential real estate never exceeded 1.7 times that of household after-tax income. In 2004, 2005 and 2006, it exceeded 2.0 times household after-tax income.
Chart 5
In sum, I would characterize the previous economic expansion as better living through credit, to paraphrase DuPont’s slogan. So, the strength of the previous economic expansion that some yearn to return to was partially due to a financial system that had the capital to support a lot of lending, a Fed that was more than willing to aid and abet financial institution excess lending and lax credit-underwriting standards. Those were the days, my friend. You may have thought that they'd never end, but they have. Yes, after the onset of the last financial crisis, the Fed went on a credit-creation binge, which now has ended. But the increase in the Fed’s contribution to credit was offset by a pullback in private financial institutions’ provision of credit. Although some private financial institutions might desire to relax their credit-underwriting standards more aggressively, their regulators will not allow it.

Now, let’s look at the demographic factor that will retard U.S. growth in real GDP for decades to come. The trend growth rate of output for any economy is a function of the trend growth rate in the economy’s working-age population and the trend growth rate in the economy’s productivity and technological advance. Forecasting productivity growth and technological advance is difficult. Projecting population cohorts is much less difficult. Chart 6 contains Department of Census actual and projected 10-year compound annual growth rates (CAGR) of the U.S. 16- to 64-year old population from 1970 through 2060. In 1980, the 10-year CAGR of the U.S. working-age population was 1.8%, in 2000, it was 1.3% and in 2020, it is projected to be 0.4%. You get the picture – growth in the U.S. working-age population is projected to slow significantly in the decades ahead. Barring some offsetting surge in productivity growth and/or technological advance, this projected slowdown in the growth of the U.S. potential labor force implies slower growth in U.S. real GDP than what we have experienced in previous decades.
Chart 6

But wait. There’s more. And it’s not good. Chart 7 shows the 10-year moving average of the ratio of the U.S. working-age population, the potential “makers”, to the U.S. population too young or too old to work, the potential “takers”. The ratio of potential makers to potential takers just recently peaked at around 1.9 and is projected to fall steadily to about 1.5 in 2040 before leveling off. In other words, in 2010, there were 1.9 potential makers in the U.S. per potential taker. This is projected to drop in 2040 to 1.5 potential makers per potential taker. The implication of the projections in Charts 6 and 7 is that growth in per capita real GDP will be slowing in the decades ahead. Why? Growth in the population producing goods and services will be slowing, which, all else the same, means that growth in total output also will be slowing. At the same time, there is projected to be faster growth in the part of the population too young or too old to work relative to those of working age. This implies future slower growth in output relative to the total population – working age and non-working age .


Chart 7

Perhaps as important, Charts 6 and 7 also might imply future slower growth in real per capita consumption, depending on what happens to the growth of imported goods and services. With growth in per capita real output slowing in the U.S., there would need to be an acceleration in the growth of imports to prevent a slowing in the growth of U.S. per capita consumption.  This could give a whole new meaning to “the hunger games”! My advice is be kind today to your children and grandchildren, the current and future makers, so that they will throw a few crumbs your way in the decades ahead.

Assuming that society will moderate the slowdown in the growth of consumption per taker, an increase in the real equilibrium interest rate is required. If the takers are not going to bear the full brunt of the slowdown in the growth of per capita output, then the makers need to be induced to slow their consumption. This inducement, one way or another, will result in a higher equilibrium real interest rate. Suppose the government provides the takers with funds with which to cushion the slowdown in the growth of their consumption. If the government increases its borrowing to obtain these funds, then, all else the same, the real interest rate will rise. If the government increases its taxes on the makers to obtain these funds, then the makers will cut back on their lending in order  to try to cushion the slowdown in the growth of their consumption, which, all else the same, will drive up the real interest rate.

Now, of course, there could be some mitigating factors to this dark economic scenario. People might delay retirement. This would prevent growth of the makers from falling as much as projected. We could accept more working-age immigrants, again preventing growth of the makers from falling as much. There could be extraordinary increases in productivity and advances in technology, which would offset the slower growth in the working-age population in terms of output growth. And to some degree, these mitigating factors are likely to occur. But just to be prudent, I still would plan on a slower trend rate of growth in U.S. per capita real GDP in the decades ahead.

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