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.
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.
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
Senior Economic and Investment Advisor
Legacy Private Trust Company of Neenah, Wisconsin