Monday, March 16, 2015

The Fed -- Drunken Coxswain of the SS America

March 16, 2015

The Fed – Drunken Coxswain of the SS America

Back on January 25, I penned a piece entitled “The Fed – Lucky or Smart?”. In that commentary I argued that the Fed was managing the supply of total thin-air credit, i.e., the sum of commercial bank credit and depository institution reserves at the Fed, in a responsible manner such that growth in nominal economic activity would neither be too hot nor too cold. I noted that this Fed management of the supply of thin-air credit in mid January was more likely due to luck than to “smarts” on the part of our central bank. I also implicitly posed the question: What if the Fed’s luck should change for the worse without its “smarts” changing for better? Well, that question now is relevant. After rebounding to a rate approximately equal to its long-run median, growth in total thin-air credit sharply decelerated in February, both on a year-over-year basis as well as a three-month basis (see Chart 1).
Chart 1
In the first nine months of 2014, the year-over-year growth rate of total thin-air credit averaged 8.8% per month. In the final three months of 2014, the average monthly growth rate sank by 300 basis points to 5.8%. Then in January 2015, the year-over-year growth rate of total thin-air credit rebounded to 7.5% only to sink to 4.1% in February. The coxswain is the person in charge of steering a ship. It seems as though the Fed coxswain in charge of steering the U.S. economy should be tested for sobriety because she appears to be steering an erratic course.

One could challenge my allegation of a drunken Fed coxswain by questioning whether the sharp deceleration in the growth of thin-air credit, save for February’s rebound, has had any effect on economic activity. I submit it has.

Firstly, I want to present exhibits of the recent behavior of the U.S. economy that will either not ever be revised or will be revised only minimally. First up is the ISM Manufacturing Purchasing Managers’ Composite Index (PMI).  As shown in Chart 2, the PMI has declined in each of the past four months ended February 2015.
Chart 2


Unit sales of light motor vehicles have contracted in each of the past three months ended February 2015, as shown in Chart 3.
Chart 3



Continuing state unemployment insurance claims have increased in each of the past four months, as shown in Chart 4.
Chart 4
Because of its history of frequent and often significant revisions, I have less faith in the reliability of recent observations of nominal retail sales. But they paint the same general picture of the more reliable economic indicators cited above – that the economy has hit a “soft patch”.  Total nominal retail sales have contracted in each of the past three months ended February 2015, as shown in Chart 5. Shown also in Chart 5 is that nominal retail sales excluding those of gasoline stations contracted in two of the past three months ended February 2015. It was against my better judgment that I excluded nominal gasoline sales from nominal retail sales. Yes, I know that when gasoline prices fall, nominal sales of gasoline also decline because households do not instantaneously drive more due to the lower gasoline prices. But with less of their nominal income being spent on gasoline, households might increase their nominal expenditures on other more discretionary goods and services by an amount equal to their nominal gasoline expenditure “savings”. This did not happen in each of three months ended February 2015.
Chart 5

One tangential thought regarding the February 2015 retail sales report. The consensus estimate of the change in total nominal February retail sales was an increase of 0.4%. The consensus did not even get the sign of the change correct. The Census Bureau reported that February total retail sales decreased by 0.6%. What was the common excuse for the big miss by the consensus? Blame it on the weather. But, wait a minute. The economic forecasters did not have to forecast the February weather. The actual February weather was a known fact when the forecast of February retail sales was made.  Yes, the winter weather of this past February was unusually severe. But why wasn’t this fact incorporated into economists’ collective forecast of February retail sales?

I know that forecasting monthly economic data accurately is very difficult. I know that if a reporter calls you for a forecast and you tell him/her that you don’t have a clue, that reporter won’t call you again. And if reporters stop calling you, your job could be in jeopardy, because what, after all, is the principal function of a Street economist? Marketing the name of your employer. Why doesn’t some enterprising economics reporter do a study on the accuracy of consensus forecasts of economic data? Perhaps if the media could be weaned off this mugs game, then Street economists could do something more useful, such as conducting research as to what really drives the cyclical behavior of the economy.

But I digress. Back to the drunken Fed coxswain. Why did growth in total thin-air credit take a dive in February 2015 and why was it relatively weak in November and December 2014? Was it because of weak growth in the commercial bank credit component? No. The data plotted in Chart 6 show that commercial bank credit growth, both on a year-over-year basis as well as a three-month annualized basis, has been quite strong.
Chart 6

That leaves but one explanation for the recent weakness in total thin-air credit growth – weakness in the Fed component, i.e., depository institution reserves at the Fed. This is illustrated in Chart 7. Given the strong growth in commercial bank credit in recent months, it is entirely appropriate that Fed credit growth should have slowed from what it was when the QE III policy was being pursued. But the Fed has overdone it. In September 2014, the year-over-year change in Fed reserves was plus 17.3%. In February 2015, it was minus 10.1%. In the three months ended 2014, the annualized change in Fed reserves was plus 16.4%. In the three months ended February 2015, it was minus 29.5%.

Chart 7
The Fed is steering its component of thin-air credit like a drunken coxswain. As a result, total thin-air credit is behaving in a similar fashion. And as a result of these frequent and, most likely, unintentional course changes in thin-air credit growth, my near-term forecasts of the pace of economic activity also have become erratic. The erratic behavior of my economic forecasts is inconsequential. But what is consequential is the effect on the economy and financial markets.  If the Fed continues to “steer” growth in thin-air credit with these seemingly erratic and random course changes, then the economy will behave in a volatile fashion, which will impart volatility to the financial markets. Other than short-term financial-market traders, no one will benefit from this.

There is continued interest in Congress to impose some “rules” on the Fed as to how it should conduct monetary policy. I am sympathetic to the general notion of imposing rules on the Fed – but not Taylor’s [interest rate] Rule. We will have to leave a discussion of new rules on the Fed for another commentary.

Paul L. Kasriel
Founder and Administrative Asst., Econtrarian, LLC
1-920-818-0236
Sr. Economic & Investment Advisor, Legacy Private Trust Co., Neenah, WI




Thursday, February 19, 2015

Yes, There Will Be Growth in the Spring

February 19, 2015

“Yes, There Will Be Growth in the Spring”
                                                                                                                     Chance, the Gardener (Google it)

Looking past the large upward revision to November 2014 nonfarm payrolls, you might have noticed that the U.S. economy has entered, in the words of the Federal Reserve’s version of Chance, the Gardener, Alan Greenspan, a “soft patch”. In recent months, labor conditions have weakened, manufacturing activity has hit a wall, consumer spending has waned and residential real estate demand has sunk. This “soft patch” is illustrated in Charts 1,2,3 and 4, which contain representative data that will not be revised radically, if at all.
Chart 1
                                            
Chart 2

Chart 3
Chart 4

I believe this current weakening in the pace of U.S. economic activity is primarily the result of the past sharp deceleration in the growth of thin-air credit, thin-air credit being defined here as the sum of commercial bank credit and reserves of depository institutions held at the Federal Reserve.  As I have argued ad nauseam, there is a positive correlation between lagged values of thin-air credit growth and the growth of economic activity. Chart 5 shows the behavior of thin-air credit in the 12 months ended January 2015 in terms of its three-month annualized growth and its month over year-ago month percent change. There was a noticeable deceleration in the growth of thin-air credit in October, November and December 2014, followed by a sharp re-acceleration in January 2015.






Chart 5

Chart 6 shows the behavior of the two components of thin-air credit in terms of their three-month annualized percent changes.
Chart 6

With the cessation of Fed QE securities purchases in October 2014, the Federal Reserve component of thin-air credit, depository institution reserves held at the Fed, has entered an outright contractionary phase. But at the same time that the Fed’s contribution to thin-air credit has been diminishing, commercial banks’ contribution has been increasing. The acceleration in commercial bank credit in the three months ended January 2015 has largely been responsible for the re-acceleration in year-over-year and three-month annualized growth in total thin-air credit in January 2015.

Barring a sharp deceleration in commercial bank credit in the next several months, a re-acceleration in total thin-air credit growth should be sufficient to extricate the U.S. economy from its current “soft patch”. So, to paraphrase Chance, the Gardener: “Yes, there will be stronger growth in the U.S. economy in the spring.” The current economic-activity “soft patch” likely has the FOMC leaning toward making no monetary policy changes at its June 16-17 meeting. If the pace of economic activity picks up in the second quarter, as I expect, the lag in the reporting of economic data might still stay the FOMC’s hand in June. If I am right about a spring pick-up in the pace of economic activity, however, look for some overt FOMC tightening action at the July 28-29 meeting.

Paul L. Kasriel
Senior Economic & Investment Advisor
Legacy Private Trust Co. of Neenah, WI
Founder, Econtrarian, LLC
econtrarian@gmail .com
1-920-818-0236

Sunday, January 25, 2015

The Fed -- Lucky or Smart?

January 25, 2015

The Fed – Lucky or Smart?

Given the rapid growth in total thin-air credit, i.e., the credit created by the Fed and depository institutions, during most of 2014, the Fed was correct in phasing down the amount of securities it was purchasing if it wanted to avoid creating another asset bubble and/or an acceleration in price increases of goods and services. But when the Fed ended its securities-purchase program in October 2014, it appeared as though growth in total thin-air credit would slow precipitously in 2015 without some contribution from the Fed. This projected 2015 precipitous slowing in total thin-air credit prompted me to write a commentary entitled “2015 Is Shaping Up to Be a ‘Turkey’ of a Year for the U.S. Economy and Stock Market” on November 17, 2014. But, alas, something has changed since mid November. Namely, commercial banks have stepped up their thin-air credit creation markedly, partially compensating for the sharply-reduced Fed thin-air credit creation. As a result, if current trends persist, a big “if”, 2015 is beginning to look better in terms of the performance of the U.S. economy and risk assets than I anticipated in mid November of last year.

Chart 1 is reproduced from my November 17 commentary. The data at that time showed that year-over-year growth in the sum of bank credit and depository institution reserves at the Fed had slowed to 6.8% in October 2014 after having been in the range of 8.4% to 9.8% earlier in 2014. Assuming that bank credit would continue to grow at its October 2014 year-over-year rate of 6.5% and assuming that reserves at the Fed would remain constant at their October level, by December 2015, year-over-year growth in total thin-air credit would have slowed to 5.0%. If bank credit were to increase at a compound annual growth rate (CAGR) of 4.8%, its CAGR for the three months ended October 2014, then, assuming no growth in reserves at the Fed, total thin-air credit would have ended 2015 with year-over-year growth of just 3.9%. Either way, back in mid November 2014, it looked as though 2015 was shaping up to be a year of a sharp deceleration in the growth of thin-air credit.
Chart 1


But, a funny thing happened thereafter. Growth in bank credit accelerated. As shown in Chart 2, for the week ended January 14, 2015, year-over-year growth in bank credit has moved up to 8.3%. For the 13-weeks ended January 14, 2015, the CAGR in bank credit was 11.2%!
Chart 2
Even with the sharp deceleration in the growth of depository institution reserves at the Fed, growth in total thin-air credit is once again ascending, as shown in Chart 3. In the week ended January 14, year-over-year growth in total thin-air credit stood at 8.2%.
Chart 3
If growth in bank credit were to persist at its current year-over-year pace of 8.3% and reserves at the Fed were to remain at their current level, then a year from now, total thin-air credit will have increased by 6.6%. This compares with 8.2% growth in total thin-air credit in the 52 weeks ended January 14, 2015 and long-term median annual growth in total thin-air credit of about 7-1/2%. If total thin-air credit growth were to repeat in the next 52 weeks at the 8.2% it registered in the past 52 weeks, there would be increased risk of inflating an asset-price bubble and/or sowing the seeds of undesirably-high goods/services price inflation. So, bringing down the growth in total thin-air credit by about 150 basis points from it prior 52 weeks’ growth and to a rate about 100 basis points below its long-run normal growth seems to me to be a “smart” policy move on the part of the Fed.

When the Fed ceased its active program of securities purchases last October, did the Fed anticipate that growth in commercial bank credit would soon accelerate, partially offsetting the extreme depressing effect on total thin-air credit growth emanating from the Fed’s cessation of securities purchases?  Given that to my knowledge the Fed has never publicly rationalized its securities-purchase program in terms of augmenting the supply of credit in the economy nor has the Fed publicly commented on the quantity of depository institution credit being created, there is little reason to believe that the recent fortuitous acceleration in commercial bank credit, fortuitous for the economy and the stock market, was anticipated by the Fed. But if the Fed isn’t smart, being lucky is a good substitute. By either intelligence or luck, if the Fed has engineered growth in total thin-air credit of about 6-1/2% 52 weeks from now, 2015 will likely to have been a year of reasonably good economic growth and reasonably good stock market performance – not as good as 2014, but better than what things were shaping up to be in mid-November, 2014. But what if bank credit growth were to suddenly plunge? What luck could we count on for the Fed to resume securities purchases in order to prevent a sharp deceleration in the growth of total thin-air credit as was imminent back in mid-November, 2014?

Paul L. Kasriel
Founder & Musical Director, Econtrarian, LLC
1-920-818-0236

Sr. Economic & Investment Advisor, Legacy Private Trust Co., Neenah, WI

Sunday, December 21, 2014

The 2014 Festivus Airing of Grievances

Embargoed until 5 PM CST, December 23, 2014

The 2014 Festivus Airing of Grievances

Well, it’s that time of the year again for the airing of grievances.  And I’ve got a lot of problems with you people! First of which are those of you (PK, NYT?) who insist that the Fed’s QE did not result in any inflation. It all depends on your definition of inflation. If your definition is restricted to the prices of goods and services, you are right. No matter how you slice it or dice it, there has been no discernible upward trend in the price changes of consumer goods and services since the start late 2012 start of QE III, as shown in Chart 1.
Chart 1
If, however, you expand the definition of inflation to include the prices of assets, then there has been a discernible pick-up in inflation since late 2012. For households, their holding gains on assets (stocks, bonds, houses, e.g.,) scaled against the market value of their total assets have moved up noticeably since the onset of QE III in late 2012, as shown in Chart 2. In fact, asset inflation in 2013, according to this measure, was approaching the housing-bubble highs of 2005-06.
Chart 2
You don’t think that QE had anything to do with asset inflation starting in late 2012? Check out Chart 3, which shows the behavior of credit granted for the purchase and carrying of securities and thin-air credit, i.e., the sum of credit created by depository institutions and credit created by the Fed in the form of depository institution reserves held at the Fed and their vault cash. Perhaps asset-price inflation will moderate in 2015 as growth in thin-air credit does.
Chart 3

My next grievance with you people is your dark-cloud reaction to the recent decline in petroleum prices. When these prices rise, the talking heads warn of dire economic consequences. When they fall, the talking heads also warn of dire consequences. My approach to ascertaining whether the recent decline in energy prices is a “good” economic development for the U.S. economy, in particular, and the global economy, in general, is to keep in mind that more is better than less. That is, if more energy is available, then more of the final goods and services we consume can be produced. Think of an agriculturally-based economy. Which will contribute to higher standard of living for the residents of this economy – a bumper crop or a lost crop? The bumper crop, obviously. Similarly, more energy production is better than less energy production with regard to our standard of living. Chart 4 shows that U.S. energy production has been soaring in recent years. That’s a “good” thing, economically speaking.
Chart 4

Another grievance I have with you people is your Keynesian (probably not Keynes, himself, rather his subsequent interpreters) view of saving. How many times have you heard that if extra income goes to the rich, they will just save it, which won’t stimulate total spending in the economy?  But if income goes to the less rich, they will spend it, which will stimulate total spending in the economy. This popular view is that when people save, funds somehow disappear from the total spending stream of the economy. This popular view of saving is often advanced as an economic argument to buttress a moral argument for government-mandated income redistribution. But except in one case, this popular view of saving is fallacious.

What does it mean to increase your saving? It means you cut back on your current spending on goods and services relative to your income. When you cut back on your goods/services spending, what do you do with that saved income? You typically, directly or indirectly, purchase equities or bonds. In other words, you transfer some of your income, which you have voluntarily chosen currently not to spend on goods and services, to another entity, perhaps a business, a government or even another household, that currently wants to increase its spending relative to its income. So, in this case of increased saving by you, total spending on goods and services in the economy does not decline. Rather your decrease in current spending on goods and services is offset by an increase in spending by the entity that ultimately received the funds with which you purchased the stocks or bonds. So, if rich people are earning relatively more income than less rich people, total spending in the economy need not go down if the rich people save relatively more of their income. Rich people’s increased saving enables other entities to increase their current spending. The saved income does not vanish from the spending stream, as today’s Keynesian talking heads would have you believe. Rather, it gets transferred to others who are eager to increase their current spending. As an aside, if the increased saving by rich people funds spending on capital goods, all else the same, the economy’s future potential to produce goods and services is enhanced. In sum, increased saving is not a “bad” economic thing in the short run and is potentially a “good” economic thing in the long run.

 Income redistribution generally will not stimulate total spending in the economy. If income is taken from the rich and given to the less rich, the rich will react by either cutting back on their current spending and/or cutting back on their saving, which implies less spending by some other entity. Either way, the increased spending by the less rich will be offset by the decreased spending and/or saving by the rich. Thus, income redistribution will not result in a net increase in total spending in the economy. Again, there may be a moral argument for income redistribution, but there is not a macroeconomic reason for it.

Now, there is one case in which an increase in saving can lead to a decrease in total spending in the economy. If you increase your saving and choose to use your extra unspent income to increase your balances at depository institutions, total spending in the economy will decline, all else the same. But wait, doesn’t the bank lend the increase in funds it received from you? Probably. But the income you received but chose not to spend now came to you from the bank of some other entity. That bank has lost funds and, thus, has to reduce its loans. So, the result of you using increased saving to build up your deposits is net decline in goods/services spending in the economy. In the 1930s, when Keynes was advancing Keynesianism, this type of saving was referred to as hoarding “money”. Back in the Great Depression, when many businesses and depository institutions were failing, people preferred to save in the form of currency and/or in deposits at super-liquid banks because of the safety of principal of these types of assets. This saving in the form of cash, or hoarding, is what motivated Keynes to have a dim view of saving in his Keynesian macroeconomic theory. Although I suspect that Keynes understood the different implications regarding total spending in the economy between an increase in saving that took the form of stocks and bonds and an increase in saving that took the form of currency and deposits, it is not clear that current adherents to Keynesian macroeconomic theory understand this difference. For whatever reason, the term “hoarding” has gone out of fashion. We now refer to saving in the form of cash (either currency or bank deposits) as a decrease in the “velocity” of money. If a decrease in the velocity of currency and deposits is not countered with an increase in the supply of currency and deposits, then nominal spending in the economy will decrease.

I have one last grievance to air. This one, however, is not with you people. Rather it is with me, people! Throughout 2014, I had been telling you people to steer clear of bonds, especially investment-grade bonds, because I had thought that bond yields would rise. The reason I had thought bond yields would rise is that I also thought that 2014 growth in domestic nominal spending on goods and services would be stronger than the Fed and the consensus expected as a result of increased growth in thin-air credit. I figured that the Fed would be reluctant to pre-emptively raise the federal funds rate in 2014, but that market participants would anticipate more aggressive funds rate increases in 2015, which would result in higher bond yields in 2014. Well, growth in domestic nominal demand did turn out to be relatively robust in 2014, save for a weather-depressed first quarter. And the Fed did not raise its policy interest rates in 2014 nor even seriously threaten to do so. But Treasury bond yields did not rise during 2014. As Chart 5 shows, Treasury bond yields actually fell. The yields that did rise were those on shorter maturity Treasury coupon securities, as represented by the yield on the 2-year Treasury security in Chart 5. Perhaps market participants believe that the Fed will raise its policy interest rates in 2015 sufficiently to slow growth in economic activity in 2015 and 2016 such that goods/services price inflation will stay in check. And given the pronounced slowdown in the growth of thin-air credit in the closing months of 2014, this market “bet” might be right.
Chart 5

But I was dead wrong on the direction of bond yields in 2014. So, I’ve been pinned. That means that the airing of grievances is over for 2014 and the Festivus celebrations can now begin in earnest. 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 chest.
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
Senior Economic and Investment Adviser
Legacy Private Trust Co., Neenah, WI
1-920-818-0236