March 20, 2013
Why Not a Quantitative Target for Quantitative Easing?
When I should have been practicing my bass guitar in preparation for my band class Thursday evening, I, instead, watched the first few minutes of Federal Reserve Chairman Bernanke’s post-FOMC press conference. A number of press inquiries were related to adding specificity to the FOMC’s criteria for modifying its current $85 billion per-month purchases of securities. In the short time that I watched the press conference, Chairman Bernanke did not seem to satisfy the press on this issue. So, again, neglecting my bass guitar practice, to which I assure you, I should not neglect, I decided to write this commentary on how I would determine the management of a quantitative approach to monetary policy. I have no illusions that Chairman Bernanke will follow my suggestion. But I believe that by observing what the Fed actually does compared to my suggestion, investors can gain some valuable information as to the cyclical behavior of the economy and the cyclical behavior of riskier assets vs. less risky assets.
So, as Fareed Zakaria says on Sunday mornings, let’s get started. Plotted in Chart 1 is the relationship between the year-over-year percent change in nominal gross domestic purchases (not product) and the year-over-year percent change in total thin-air credit. If the chart looks familiar, it is an updated version of the Chart 1 I included in my February 5, 2013 tome, “The 2013 Economic Outlook – Bright Sunshine for the U.S., Periods of Cloud Abroad”. To refresh your memory, total thin-air credit is the sum of the credit extended by the Federal Reserve and the depository institution system, the latter of which is dominated by the commercial banking system. I refer to this credit as thin-air credit because it is credit that figuratively is created out of thin air, which enables its recipients to increase their current spending on goods/ services/ assets whilst not requiring its grantors or any other entity to cut back on their current spending. Hence, changes in thin-air credit, theoretically, should correlate highly with changes in total nominal spending in an economy. And this might be one of those rare cases where “ugly” facts do not spoil a “beautiful” theory. That is, from 1953 through 2007, the correlation between percent changes in total thin-air credit and percent changes in nominal gross domestic purchases – the aggregate nominal spending in the U.S. on currently-produced goods and services, be they goods and services produced in the U.S. or China, is 0.65 out of a possible maximum of 1.00. Why did I stop the correlation calculation at the end of 2007 rather than calculating it with data through the end of 2012? Because the correlation value would have fallen, detracting from my “beautiful” theory. Why would the correlation value have fallen? Because right after Lehman Brothers failed in September 2008, the Fed increased its balance sheet enormously, in part with loans to AIG and to foreign central banks, which also enlarged total thin-air credit. But because these Fed loans to AIG were, in effect, restoring some of AIG’s “depreciated” capital and because there were Fed loans of large dollar amounts to foreign central banks, the increase in Fed loans and the resulting increase in total thin-air credit had no positive impact on domestic spending.
Why isn’t the correlation 1.00 between 1953 and 2007? Primarily because some of the spending by the recipients of thin-air credit is on previously-produced goods and services, e.g., used cars, used homes or, in my case, used sailboats, or spending on financial assets. So, if the Fed wanted to conduct monetary policy in a way that would result in some steady rate of growth in aggregate nominal domestic demand, post-WWII economic history suggests it could do worse than managing the amount of credit it extends so as to hit a target rate of growth in the sum of credit it extends and the credit banks and other depository institutions extend. Assume that the Fed believed that if the economy were operating at full employment, then annual growth in nominal gross domestic purchases of around 4% would maintain full employment, would keep consumer-price inflation around 2% annually and would prevent the inflation of asset-price bubbles. Further assume that, for whatever reason, credit being extended by depository institutions was only growing at 2% annually. Under the Paul Kasriel recommendation to Chairman Bernanke, the Fed would undertake the expansion of its balance sheet, primarily through the acquisition of securities from the market, such that the sum of Fed credit and depository institution credit was boosted to an annual rate of growth of 4%. Now assume, that the growth in depository institution credit accelerates from 2% annualized to 4%, which then results in the sum of Fed and depository institution credit now growing at 6% annualized. This would be a signal to the Fed to cut back on its purchases of securities such that the sum of Fed and depository institution credit slows in growth back down to a rate of 4% annualized.
How has the Fed managed its securities purchases in recent years compared with the Paul Kasriel approach? The Fed’s first conscious decision to concentrate on a quantity of securities purchases commenced in December 2008. This first securities-purchase program, which became known as quantitative easing (QE), lasted through the middle of third quarter of 2010. During this period, the Fed purchased approximately $1.725 trillion of various types and maturities of securities from the market. Shown in Chart 2 is the behavior of depository institution credit and total thin-air credit. Throughout most of this first securities- purchase program by the Fed, represented by the yellow shaded area QE I in Chart 2, depository institution credit was contracting. Early in the QE I period, there was unusually high growth in total thin-air credit due primarily due to massive extensions of Fed credit through various lending facilities such as the discount window, loans to foreign central banks and loans to AIG. Notice, however, by the fourth quarter of 2009, despite continued Fed securities purchases, total thin-air credit was contracting. The reasons for this contraction in total thin-air credit were the contraction in depository institution credit and the reduction in Fed credit through the Fed’s various lending facilities.
Also shown in Chart 2 for illustrative purposes is a series I have named Total Thin-Air Credit “Target”. I have defined the target rate of growth in total thin-air credit as the year-over-year percent change in CBO-estimated real potential GDP plus 2 percentage points. Presumably, once full employment in the economy were achieved, the Fed would desire that nominal GDP grow somewhere in the neighborhood of the rate of growth in real potential GDP with an annual inflation rate of 2 percent. The best and the brightest economists at the Fed could work out what the rate of growth in total thin-air credit would need to be in order to hit this nominal GDP growth target. Given that the 0.65 correlation between growth in total thin-air credit and nominal gross domestic purchases, I would assume that the target rate of growth in total thin-air credit as I have defined it would be a minimum target. Back to QE I. Starting in the third quarter of 2009 and for the remainder of the QE I period, growth in actual total thin-air credit was below my illustrative target rate of growth.
Now, on to QE II. This second round of securities purchases undertaken by the Fed started in the middle of the fourth quarter of 2010 and terminated at the end of the second quarter of 2011. The Fed purchased an additional $600 billion of securities during QE II. Given that other asset items on the Fed’s balance sheet were relatively constant during QE II and that the contraction in depository institution credit was of a smaller magnitude than it was during QE I, total thin-air credit grew throughout QE II and reached my illustrative target rate of growth by the end of
Due to the resumption in growth of depository institution credit in the fourth quarter of 2011, total thin-air credit exceeded my illustrative target rate by about 1.6 percentage points. Thereafter, however, growth in total thin-air credit again dipped below my illustrative target rate, being about one percentage point below the target growth rate in the fourth quarter of 2012, the first full quarter of QE III.
The Fed will not release its first quarter 2013 flow-of-funds report, the source of total depository institution credit data, until June 6. But the Fed does release monthly bank credit data. Given that commercial bank credit now accounts for the bulk of depository institution credit, year-over-year percent changes in monthly bank credit are a close approximation for year-over-year percent changes in depository institution credit. Therefore, the year-over-year percent change in the sum of monthly bank credit and monthly Fed credit is a close approximation for the year-over-year percent changes in total thin-air credit. Year-over-year percent changes in monthly bank credit and the sum of bank and Fed credit are shown in Chart 3 through February 2013, the latest complete monthly data available. Also shown in Chart 3 is the illustrative target rate of growth for total thin-air credit. While year-over-year growth in bank credit is slowing, growth in the sum of bank and Fed credit is accelerating because of the resumption of Fed net asset purchases that commenced in mid September of 2012. In February 2013, year-over-year growth in the sum of Fed and bank credit had reached the illustrative target rate of growth of 3.8%.
Before we should hoist the “Mission Accomplished” banner for the Fed, we need to take into consideration that my illustrative target rate of growth for total thin-air credit is what the target the Fed might aim for as full employment is approached. No serious person, even the perennial FOMC hawks, would consider our current unemployment rate of 7.7% as anywhere close to full employment. Consider also that from 1953 through 2012, the median year-over-year growth in total thin-air credit was 7.25%. Acknowledging that 7.25% annual growth in thin-air credit was associated with some economic booms, still, with as much excess capacity that currently exists in the U.S. economy, 3.8% growth in total thin-air credit would appear to be rather anemic compared to this median rate of growth in total thin air credit.
But by this time in 2014, the situation could be much different. If the Fed were to hold to its current course of increasing its balance sheet by about $85 billion per month throughout 2013, this would represent a 7.1% increase in total thin-air credit in the fourth quarter of 2013 vs. 2012 assuming depository institution credit remained constant at its fourth-quarter 2012 level. Given that the capital positions of depository institutions in general are much improved, it is much more probable that depository institution credit will be rising in 2013 rather than remaining stagnant. Thus, unless the Fed soon cuts back on its securities purchases, growth in total thin-air credit is likely to be robust in 2013, which implies relatively robust growth in aggregate domestic spending on goods, services and assets.
I don’t expect the Fed to pay any heed to this commentary. But you might want to. If total thin-air credit continues to accelerate this year, it will be bullish for growth in U.S. economic activity and bullish for risk assets. If, by the end of 2013 or sooner, total thin-air credit is growing on a year-over-year basis at 7% or more, be prepared for U.S. bond yields of all stripes to have risen significantly in anticipation of Fed interest rate hikes well before 2015, when the majority of FOMC members now believe rate increases will commence.
Paul L. Kasriel
Senior Economic and Investment Adviser, Legacy Private Trust Co.