June 24, 2013
Does Fed “Tapering” Represent Fed Tightening?
It
depends. On what? Whether a reduction in the amount by which Federal Reserve
purchases of securities increases each month represents a tightening in
monetary policy depends on how much loans and securities on the books of
private depository institutions (i.e., commercial banks, S&Ls and credit
unions) change each month. Whether Fed monetary policy gets more restrictive or
more accommodative when Fed the Fed begins to taper the amount of securities
its purchases per month depends on what happens to the growth in the SUM of Fed
credit and depository institution credit. If at the time the Fed tapers the
pace of its asset purchases growth in the SUM of Fed and depository institution
credit slows, then, in my view, Fed
monetary policy would be becoming more
restrictive. Conversely, if at the time the Fed tapers the pace of its
asset purchases growth in the SUM of Fed and depository institution credit increases, Fed monetary policy, in my
view, would be becoming more accommodative.
With
regard to its impact on domestic nominal spending on goods, services and
assets, both physical and financial, in theory it makes no difference whether
credit is created by the Fed or by the depository institution system in a fractional-reserve regime.
In both cases, credit is being created figuratively out of “thin air”, which
implies that the recipient of this credit is able to increase its current
spending while neither the grantor of this credit nor any other entity need
restrain its current spending.
Chart
1 shows the behavior of the SUM of Federal Reserve and depository institution
credit, depository institution credit by itself and nominal gross domestic
spending on currently-produced goods and services. The data are year-over-year
percent changes of quarterly observations from 1953:Q1 through 2013:Q1. The
contemporaneous correlation between gross domestic purchases and the credit SUM
over this entire period is 0.56 out of possible maximum 1.00. The
contemporaneous correlation between gross domestic purchases and depository institution
credit by itself over this entire period is higher
at 0.66. At first blush, this would seem to indicate that the behavior of
depository institution credit by itself is what drives nominal domestic
spending, not the SUM of Fed and
depository institution credit. If, however, the period beginning with 2008:Q2
through 2009:Q4 is excluded, the contemporaneous correlation between gross
domestic purchases and depository institution credit by itself slips to 0.62 while the contemporaneous
correlation between gross domestic purchases and the credit SUM rises to 0.66. Thus, if a cogent
argument can be advanced as to why this subperiod should be excluded, it can be
argued that the impact of Fed “tapering” on the thrust of monetary policy
depends on the behavior of the SUM of Fed and depository institution credit.
Chart 1
The
reason the inclusion of this subperiod (shaded in Chart 1) reduces the
contemporaneous correlation between the two series is that the sharp
year-over-year increase in Federal Reserve credit that started in 2008:Q3 and
reached its zenith in 2008:Q4 was related to extraordinary increased liquidity
demands by financial institutions and funds advanced by the Fed to AIG. During
this period, financial institutions were reluctant to lend to each other in the
ordinary course of business. In response to this, the Fed threw open its credit
facilities to depository institutions and other financial intermediaries in
order to prevent a wave of failures throughout the global financial system. In
the event, the increase in Fed credit was not being used as “seed” money by
depository institutions to create multiple amounts of new credit. Rather, this
Fed credit was just being used, at best, to fund outstanding credit previously
granted by depository institutions. The Fed credit extended to AIG was used to
“make whole” AIG creditors, not for AIG to expand its earning assets (loans and
securities).
Since
the onset of the financial crisis in late 2008, the Fed’s contribution to the
SUM of Fed and depository institution credit has increased significantly, as
shown in Chart 2. The rebound in the credit SUM beginning in 2010 has been
dominated by Fed credit creation. If Fed were to begin tapering its securities
purchases later this year, as Fed Chairman Bernanke indicated at his June 19
news conference is the current conditional
plan (conditional on economic activity unfolding according to the Fed’s current
forecast) and if depository
institutions did not add to their holdings of loans and securities
commensurately, then growth in the credit SUM would slow, which, in my view,
would represent a “tightening” in monetary policy.
Chart 2
Commercial bank credit, the dominant source of depository
institution credit, contracted in May at an annualized rate of 1.8%. The June
weekly data, however, suggest a resumption of growth in commercial bank credit.
The latest Federal Reserve survey of bank lending terms showed that there was a
significant increase in the percentage of survey respondents stating that their
institutions had eased their lending terms. With house prices again on the
rise, future home mortgage write-offs by depository institutions will continue
to diminish. This will enhance the already high (in general) capital ratios of
these institutions, thus enabling them to increase their loans and securities.
So, it is likely that depository institutions will be stepping up their credit
creation as the Fed begins to moderate the pace of its credit creation.
Let’s contemplate some numerical scenarios for the behavior
of the SUM of Fed and depository institution credit in 2013. Given 2013:Q1
actual (until revised) data and assuming that Fed credit increases by $85
billion per month over the remainder of the year (i.e., no tapering) while
depository institution credit remains frozen at its 2013:Q1 level, then the
credit SUM will have grown by 7.1% Q4-over-Q4 in 2013. Call this Scenario I. This
compares with 2012 growth of 2.8% and 1953 – 2012 median annual growth of 7.25%.
In Scenario II, assume that the Fed begins to taper it securities purchases at
the beginning of 2013:Q4, cutting its current purchase rate of $85
billion-per-month in half. Further assume that depository institution credit
remains frozen at its 2013:Q1 level. Under Scenario II, the credit SUM will
have grown by 6.2% Q4-over-Q4 in 2013. In Scenario III, assume that the Fed
tapers its securities purchases as it did in Scenario II, but that depository
institution credit increases by the amount that the Fed cuts. Thus, under
Scenario III, the credit SUM will have grown by 7.1% Q4-over-Q4 in 2013, the
same as in Scenario I. Is Scenario III farfetched in terms of the growth in
depository institution credit? Hardly. Scenario III would imply 2013 Q4-over-Q4
growth in depository institution credit of only 0.9%. This compares with 2012
growth in depository institution credit of 3.5% and 1953 – 2012 median annual
growth of 7.5%. Based on this what-if exercise,
I do not believe the Fed’s tapering
in securities purchases later this year will represent a tightening in monetary
policy as depository institutions are likely to increase their net acquisitions
of loans in securities by at least as
much as the Fed is likely to cut its rate of securities purchases. Rather, Fed
tapering is more likely to represent
an effective easing in monetary
policy inasmuch as depository institutions will probably increase their net
acquisitions of loans and securities by a greater
amount than the Fed cuts its rate of securities purchases.
In the wake of Chairman Bernanke’s announcement of the Fed’s
conditional plan to begin moderating
the pace of its securities purchase later this year, the prices of risk assets,
equities in particular, fell. Whether this decline in the prices of risk assets
represents a buying opportunity or the onset of bear market depends critically
on the behavior of the SUM of Fed and depository institution credit going
forward. If depository institutions step up their net acquisitions of loans and
securities such that growth in the SUM of Fed and depository institution credit
is maintained or even accelerates as the Fed’s contribution to this credit SUM
diminishes, then the current sell-off in risk assets will have been a buying
opportunity. Based on the scenario
analysis presented above, I would conclude that the recent sell-off in risk
assets represents a buying opportunity.
Paul
L. Kasriel
Econtrarian,
LLC
Senior
Economic and Investment Advisor
Legacy
Private Trust Company of Neenah, Wisconsin
1-920-818-0236
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