Sunday, May 22, 2016

a June Fed Funds Rate Hike Risks a September Economic Stall

May 19, 2016

A June Fed Funds Rate Hike Risks a September Economic Stall


Recent economic data, e.g., retail sales, housing starts and industrial production, suggest that the U.S. economy has awoken from its winter slumber. In addition, growth in consumer prices has accelerated of late (see Chart 1). The consensus of the Federal Open Market Committee (FOMC) is that the federal funds rate will be hiked twice by 25 basis points each time in 2016. Time’s a wastin’.  The behavior of short-term interest rates indicates that investors have been skeptical that the Fed will pull the fed-funds trigger at its June 14-15 FOMC meeting. But about a month ago, comments by Boston Fed President Eric Rosengren, no Johnny-One-Note policy hawk like Richmond Fed President Jeffrey Lacker, were interpreted to imply that financial-market participants were underestimating how soon the Fed might hike the federal funds interest rate.
Chart 1

Despite the recent acceleration in the pace of U.S. economic activity, I believe that the Fed runs the risk of causing the pace of U.S. economic activity to stall out in the late-summer or early-fall of 2016 if it raises the federal funds rate at its June 14-15 FOMC meeting. The reason I believe an economic stall would occur is, you guessed it, because of the negative effect a fed funds rate hike would have on growth in thin-air credit (the sum of the monetary base and depository institution credit).

Allow me to elaborate. The federal funds interest rate is the price of overnight credit in immediately-available funds, or reserves, created by the Fed. This price, like any price, is determined by supply and demand. The demand for reserves is determined by the amount of reserves depository institutions (primarily commercial banks) are required to hold in relation to their deposits. Depository institutions also have a demand for reserves in excess of what they are required to hold. Now that the Fed pays interest on reserves held by depository institutions, this excess demand for reserves is much higher than was the case when no interest was paid by the Fed on reserves. The supply of reserves is determined by the Fed. For example, if the Fed sells securities in the open market, the supply of reserves will decrease, all else the same. If the Fed wants the federal funds rate to rise, it needs to reduce the supply of reserves relative to the demand for reserves. When the Fed raised the federal funds rate in late December of 2015, the monetary base – the sum of reserves and currency in circulation – declined (see Chart 2). And, although the level of the monetary base rose subsequent to its dip coincident to the increase in the fed funds rate, the level of the monetary base has not returned to its level prior to the increase in the fed funds rate.
Chart 2

Now, let’s look at the recent behavior of a variant of thin-air credit, i.e., the sum of the monetary base and commercial bank credit. Chart 3 shows the annualized growth in this variant of thin-air credit on a three-month basis.  In the three months ended October 2015, thin-air credit had grown at an annual rate of 6.7%, close to its long-run median annualized growth rate of about 7%. By the three months ended January 2016, annualized growth in thin-air credit had slowed to just 1.1%. In the three months ended April 2016, annualized growth in thin-air credit had recovered to 3.8%. But that was still well below its long-run median annualized growth of 7%.
Chart 3
Now let’s reproduce the data in Chart 3, the three-month annualized growth in thin-air credit, but also show the three-month annualized growth in its components, commercial bank credit and the monetary base. This is shown in Chart 4. We can see that in March and April 2016, the three-month annualized rate of growth in commercial bank credit has moderated (6.0% in the three-months ended April 2016). Although the monetary base still is contracting, its rate of contraction has become less, only minus 2.5% annualized in the three months ended April 2016. If the Fed raises the federal funds rate in June, the contraction in the monetary base will likely become more severe, as it did after the December 2015 hike in the federal funds rate. Unless growth in commercial bank credit surges for some reason, a June increase in the federal funds rate implies further slowing in the growth to total thin-air credit from an already slow rate of growth. In turn, this would imply future slowing in the pace of nominal economic activity from a none-to-robust current pace.
Chart 4
If the Fed decides to raise the federal funds rate in June, I would expect a rally in the prices of investment-grade U.S. bonds. At the same time, I would expect a decline in the prices of riskier financial assets.

Paul L. Kasriel
Senior Economic and Investment Advisor
Founder and Outplacement Officer of Econtrarian, LLC
1-920-818-0236


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