July 17, 2017
Have Bundesbank Agents Infiltrated the Fed?
Germany’s central bank is the Bundesbank. Prior to the commencement of trading of the euro in January 1999, the Bundesbank conducted Germany’s monetary policy. The Bundesbank has a reputation for pursuing general price-level stability above all else. You might say that the Bundesbank has inflation phobia. The reason for this Bundesbank inflation phobia is the remembrance of the hyperinflation Germany experienced between World Wars I and II. Given the U.S. central bank’s recent actions, it would almost seem that the Fed has developed inflation phobia too.
Although the U.S. does not have general price-level stability, the rate of change of the consumer price index (CPI), no matter how you slice or dice it, is absolutely low. This is illustrated in Chart 1. Plotted in Chart 1 are the 12-month percentages changes in monthly observations of various CPI measures – the CPI including all of its goods/services items, the CPI excluding its energy goods/services items and the Cleveland Fed’s 16% trimmed-mean CPI. The 16% trimmed-mean CPI eliminates components showing extreme monthly price changes. Eight percent of the weighted components with the highest and lowest one-month price changes are eliminated and the mean is calculated from the remaining components, making the 16% trimmed- mean CPI less volatile than either the CPI or the CPI excluding prices for energy goods/services. In the 12 months ended June 2017, the percentage changes in the CPI with all items, the CPI excluding energy items and the 16% trimmed-mean CPI were 1.6%, 1.6% and 1.9%, respectively. Moreover, the 12-month percentage change in the CPI, no matter how you measure it, has been trending lower since the first two months of 2017.
Plotted in Chart 2 are the three-month annualized percentage changes in the same variations of the CPI. In the three months ended June 2017, the annualized percentage changes in the CPI with all items, the CPI excluding energy items and the 16% trimmed-mean CPI were 0.06%, 1.05% and 1.05%, respectively.
Admittedly, this does not represent literal general price-level stability, but these rates of consumer price inflation are low in an historical context and in absolute terms. Of course, just because price inflation currently is quiescent does not mean that it will remain quiescent. According to the late and great economist, Milton Friedman, inflation is always and everywhere a monetary phenomenon. Has the Fed sown the monetary seeds of future higher inflation? To answer this question, consider the data in Chart 3. Plotted in Chart 3 are the year-over-year percent changes in the annual average observations of the sum of depository institution credit and the monetary base (currency plus reserves of depository institutions held at the Fed) along with the year-over-year percent changes in the annual average observations of the Personal Consumption Expenditures chain price index. As regular readers of my irregular commentaries recall, the sum of depository institution credit and the monetary base is what I call “thin-air” credit because both components are created figuratively out of thin air. In Chart 3, observations of thin-air credit growth have been advanced by two years because this results in the highest correlation coefficient, 0.59, between the two series. That is, from 1953 through 2016, the highest correlation between growth in thin-air credit and consumer inflation occurs when growth in thin-air credit leads consumer inflation by two years. So, what is happening to thin-air credit growth today has its maximum effect on consumer inflation two years later. (This has important implications as to how U.S. monetary policy should be conducted, but the discussion of this is for a later commentary.) Thin-air credit grew 5.7% in 2013, 6.7% in 2014, 4.0% in 2015 and 4.3% in 2016. (As a point of reference, the median year-over-year growth in thin-air credit from 1953 through 2016 was 7.1%.) So, growth in thin-air credit slowed in 2015 and 2016 from its growth in 2013 and 2014, suggesting that consumer inflation should slow in 2017 and 2018 compared with 2015 and 2016.
Let’s home in on the recent monthly behavior of thin-air credit. Plotted in Chart 4 are the 12-month percent changes in the sum of commercial bank credit and the monetary base along with the end-of-month Federal Open Market Committee (FOMC) target levels for the federal funds rate. Note that growth in this subcomponent of thin-air credit has been trending lower in recent years, slowing to 2.6% in the 12 months ended June 2017. Notice also that the federal funds rate has been trending higher. Coincidence? I don’t think so.
In order for the Fed to push the federal funds rate higher, it must reduce the supply of the monetary base relative to the demand for the monetary base. Chart 5 shows that as the target level of the federal funds rate was increased by one full percentage point in the 19 months ended June 2017, the monetary base contracted by $308 billion.
As the federal funds rate moves higher, banks’ loan rates move higher, too. As bank loan rates move higher, the quantity demanded of bank credit decreases. Chart 6 shows that the 12-month growth rate in bank credit has been decelerating as the federal funds rate has been rising, especially so starting in late 2016.
To reiterate, not only is the current rate of consumer inflation low, but the slowing in the growth of thin-air credit suggests that the rate of inflation two years from now will remain low. While the lag between thin-air credit growth and inflation is about two years, the lag between thin-air credit growth and growth in real aggregate demand for goods and services is much shorter. And for those who don’t have their heads in the sand, the evidence of this abounds. Real GDP growth in the 1Q:2017 was a paltry 1.4% annualized. And although second-quarter real GDP growth is likely to be higher than that of the first quarter, it is unlikely to be that much higher. As shown in Chart 7, annualized growth in second-quarter real retail sales was 1.3%, only marginally faster than the first quarter’s 1.1%. Nominal private construction spending contracted at an annualized 4.7% in the two months ended May, as shown in Chart 8. Shipments of manufactured goods have stalled out after their December 2016 surge (see Chart 9). Annualized growth in manufacturing production slowed to 1.4% in the second quarter vs. 2.1% in the first quarter (see Chart 10).
Allegedly, nonfarm payrolls increased by 581 thousand in the three months ended June 2017. There must have been more frequent and longer coffee breaks because the sales and production data do not point to much being produced or sold. Perhaps employers are hiring in anticipation of the big public/private infrastructure program talked about during the last presidential campaign.
Fed officials indicate that there is at least one more hike in the federal funds rate coming in 2017. Why would the Fed want to do this in the face of low inflation and weak economic growth? Fed officials indicate that the Fed will begin paring down its holdings of securities at some point in 2017. All else the same, a decline in Fed securities holdings will reduce the monetary base. All else the same, a reduction in the monetary base will result in an increase in the federal funds rate. Why does the Fed feel the necessity to reduce its holdings of securities in the face of low inflation and weak economic growth?
Does the Fed have a working monetary policy compass? The chairman of the House Financial Services Committee, Representative Jeb Hensarling of Texas, is in favor of the Fed determining and announcing some rule to guide the FOMC on its monetary policy decisions. President Trump has nominated Randal Quarles for one of the three vacant Fed Board governors’ seats. Although primary remit of Quarles will be regulatory supervision of financial institutions, when (not if) confirmed by the Senate, he will have one vote on the FOMC. According to a Politico article, Quarles is in favor of the Fed using the Taylor Rule as the compass by which monetary policy is navigated. Governor Yellen’s term as chairperson of the Federal Reserve Board ends February 3, 2018. If she is not re-nominated by President Trump, which I believe is a high probability outcome, she would likely resign from the Federal Reserve Board rather than remain as a mere governor. What all of this implies is that President Trump will likely have nominated and the Senate confirmed four of the seven governorships to the Federal Reserve Board by February 2018, one of whom will be the next chairperson. Who knows, one of the nominees might even be John Taylor, the namesake of the Taylor Rule. Regardless, there is going to be increasing pressure on the Fed to adopt some rule to guide its monetary policy decisions, especially with real economic growth disappointing in 2017. Perhaps in my next commentary I will discuss why the Taylor Rule is the wrong rule for the Fed to adopt. Can you guess what might be involved in the rule I would favor?
This is the first commentary I have published since early April. I appreciate those of you who have inquired as to my health or whether I have run off to play the bass guitar in a blues band. My health appears to be good. Not so my bass guitar playing. Some of my time was spent putting together presentations for Legacy Private Trust Company, the contents of which I have covered in my previous commentaries. Similar to President Trump, I have been watching too much television. As an antidote to the news, I got hooked on a Netflix comedy series, “Rake”. The series revolves around a rakish (hence, its name) Aussie defense lawyer. In the first episode of Season 1, the lawyer agrees to defend a prominent Australian economist who is charged with murder. Did I mention that the economist is an admitted cannibal? Talk about putting the “dismal” in the dismal science! I took some time out to walk my lovely daughter down the aisle in her marriage to fine young man (who knows his Seinfeld better than I). Lastly, I have been occupied with a 50th anniversary gift from my wife, a beautifully restored 50-year old classic sailboat – a Pearson Commander 26. I will try to be more productive, but sailing season up here in tundraland lasts until early October!
Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic and Investment Advisor
“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte