September 23, 2013
Even with No Fed Taper, Look for Slower Growth in Nominal Transactions
The Fed decided on September 18 to maintain its rate of securities purchases at $85 billion per month rather than reducing or “tapering” the amount of its monthly securities purchases as was, for reasons not entirely clear to me, was widely expected by the financial market cognoscenti. Many analysts interpreted the Fed’s decision not to taper as one of maintaining the same degree of monetary policy accommodation. As Milton Friedman used to teach, the degree of accommodation or restriction of monetary policy cannot be evaluated in isolation, but rather must be evaluated in relation to the actions of the banking system. For example, in the early 1930s, Federal Reserve credit grew quite rapidly. In isolation, this appeared to be a very accommodative monetary policy. However, given that banks were contracting their credit by amounts greater than the amounts of credit being created by the Fed, monetary policy turned out to be very restrictive, relatively speaking. Similarly, this econtrarian would argue that the Fed’s decision to maintain its securities purchase program at $85 billion per month will result in a tightening in monetary policy if recent trends in the behavior of commercial bank credit persist. This tightening in monetary policy is likely to result in slower growth in nominal transactions. That is, we should expect to see slower growth in the nominal domestic demand for goods and services and/or a slower rate of increase in the prices of risk assets such as equities. Mind you, had the Fed decided on September 18 to taper the rate at which it was going to purchase securities, this would have resulted in an even greater tightening in monetary policy than the no-taper decision did.
As shown in the chart below, in three of the four months ended August, commercial bank credit – loans and securities on the books of commercial banks – contracted. Because interest rates rose sharply during this period, banks would have experienced unrealized losses on their securities holdings. In accounting for the level of securities holdings of commercial banks in its H.8 release, the Fed adjusts the value of these bank-held securities by their unrealized gains or losses. Because of the interest rate increases in the four months ended August 2013, these unrealized losses would have exaggerated the decline in bank credit. In order to compensate for these unrealized securities losses, I have adjusted commercial bank securities holdings by a memo item in the H.8 report, “unrealized gains (losses) on available-for-sale securities”. To emphasize that recent weakness in total commercial bank credit is not due solely to declines in securities holdings, the chart also contains the month-to-month behavior of commercial bank loans and leases. In two of the past four months ended August, commercial bank loans and leases have contracted.
As I have argued ad nauseam in previous commentaries, both Federal Reserve credit and commercial bank credit are credit that is created figuratively out of thin air. A net increase in thin-air credit is likely to result in a net increase in nominal transactions in an economy because no other entity in the economy need cut back on its current transactions as the recipients of this new thin-air credit increase their transactions. If commercial banks began restricting their thin-air credit creation, perhaps because of capital constraints, then, all else the same, the growth in nominal transactions in the economy would slow. But, if the Federal Reserve did not desire a slowdown in the growth of nominal transactions, it could step up its thin-air credit creation to compensate for the shortfall in commercial bank credit creation. According to this view, then, a view to which I subscribe (and apparently only I), whether monetary policy is becoming more accommodative (more restrictive) depends on whether the sum of Fed credit and commercial bank credit is growing faster (slower).
In mid-September 2012, the Fed embarked on its third round of securities purchases, QEIII. In the 11 months ended August 2013, the 11 months in which QEIII has been in effect, the Fed’s balance sheet, i.e., total factors supplying reserve funds (Federal Reserve release H.4.1) had increased by $76.4 billion per month on average. (In these same 11 months, Fed outright holdings of Treasury coupon and mortgage-backed securities increased $74.0 billion per month on average.) In the 12 months ended September 2012, the sum of Fed credit and commercial bank credit had increased 4.1%. In the 11 months ended August 2013, the time period for which QEIII has been in effect, the sum of Fed credit and commercial bank credit had increased at an annualized rate of 9.2%. To put these percentage changes in perspective, the median year-over-year change in the sum of Fed credit and commercial bank credit starting in March 1990 has been 6.7%. So, in the 12 months prior to the commencement of QEIII, this credit sum had grown 260 basis points below its longer-run median and at the end of 11 months of QEIII, this credit sum had grown 250 basis points above its longer-run median.
If, over the next 12 months, the Fed’s balance sheet continues to increase by $76.4 billion per month and total commercial bank credit remains static at its August level, then, in the 12 months ended August 2014, the sum of Fed credit and commercial bank credit will have increased by 6.7%. This represents a 250 basis point deceleration in growth from what it had been in the 11 months ended August 2013. If total commercial bank credit over the 12 months ended August 2014 contracts by 0.8%, its annualized rate of contraction in the four months ended August 2013, and Fed credit increases by $76.4 billion per month, then in the 12 months ended August 2014 the sum of Fed credit and bank credit will have increased by 6.1%. This represents a 310 basis point deceleration in growth from what it had been in the 11 months ended August 2013.
Now, annualized growth in the sum of Fed credit and commercial bank credit in the range of 6.1% to 6.7% in the context of a longer-run median growth rate of 6.7% for this credit aggregate does not represent a restrictive monetary policy in an absolute sense. But, as discussed above, if this credit aggregate does, in fact, grow in this range over the next 12 months, it would represent a move toward more restriction or less accommodation, however you want to describe it, than what prevailed in the 11 months ended August 2013. And, as it would be more restrictive/less accommodative, then we should expect a moderation in the growth of nominal transactions over the coming 12 months, which would imply a moderation in the rate of advance in equity prices.
I have to admit that I am puzzled by the recent contraction in commercial bank credit. The most recent Fed survey of bank lending terms showed an easing in those terms, which would imply faster growth in bank credit, not a contraction. Although recent unrealized losses on bank holdings of securities due to rising interest rates might have reduced bank capital, in general, bank capital ratios are higher than required. So, it is entirely possible that bank credit could start to grow again in the near future. But, in the other direction, we could be just one random number, i.e., one employment report, away from a Fed decision to reduce its rate of securities purchases, according to comments made by St. Louis Fed President Bullard on September 20. The upshot of all this is that if you want to know where the economy is headed, “follow the money’, more accurately, follow the thin-air credit, by keeping an eye on the Fed’s H.4.1 report, Factors Affecting Reserve Balances, released on Thursday afternoons and the Fed’s H.8 report, Assets and Liabilities of Commercial Banks in the U.S., released on Friday afternoons.
Paul L. Kasriel
Senior Economic and Investment Adviser
Legacy Private Trust Co. of Neenah, WI