tag:blogger.com,1999:blog-33995467759463094352024-03-12T16:57:20.773-07:00The EcontrarianPaul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comBlogger77125tag:blogger.com,1999:blog-3399546775946309435.post-56635161218902011332018-09-04T13:42:00.001-07:002018-09-04T13:43:37.538-07:00The Flattening Yield Curve -- Is It Different this Time?<div class="WordSection1" style="page: WordSection1;">
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September 4, 2018<o:p></o:p></div>
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<b><u>The Flattening Yield Curve – Is It Different this Time?<o:p></o:p></u></b></div>
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Back in mid-December 2016, the Fed started raising the federal funds rate by 0.25 of a percentage point per quarter. So, the federal funds rate has risen a cumulative 1.50 percentage points since then. When the Fed began these quarterly federal funds hikes back in mid-December 2016, the difference, or spread, between the yield on the Treasury 10-year security and the federal funds rate was 2.13 percentage points. In the week ended August 31, 2018, this spread had narrowed to 0.96 of a percentage point. Thus, since mid-December 2016 through the week ended August 31, 2018, the federal funds rate has <i>risen </i>by 1.50 percentage points as the yield on the Treasury 10-year security has <i>fallen</i>by 0.33 of a percentage point. The yield curve has flattened as a result of the combination of a <i>rise</i>in short-maturity interest rates and a <i>decline</i>in long-maturity interest rates. Unless the economic landscape changes radically in the interim, the Fed is likely to raise the federal funds rate another 0.25 of a percentage point on this coming September 26. If the recent past is prologue, the spread between the Treasury 10-year security and the federal funds rate will narrow further.<o:p></o:p></div>
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I mention this narrowing in the spread between the yield on the Treasury 10-year security and the federal funds rate, or the flattening in the yield curve, because the behavior of the yield curve has the uncanny characteristic of <i>presaging</i>the pace of real domestic demand for goods and services. That is, as the yield curve flattens, growth in real domestic demand slows <i>with a lag</i>. Conversely, as the yield curve steepens (the yield on the Treasury 10-year security rises relative to the federal funds rate), growth in real domestic demand increases <i>with a lag</i>. This <i>leading </i>relationship between the flattening/steepening behavior of the yield curve and the decreasing/increasing growth rate of real domestic purchases is shown in Chart 1 where the red bars represent the observations of the four-quarter moving average of the yield spread in percentage points and the blue line represents the year-over-year percentage changes in quarterly observations of the real gross domestic purchases (real gross domestic product plus imports and minus exports). The vertical shaded areas in the chart represent periods of business-cycle recessions. Notice that the spread between the yield on the Treasury 10-year security and the federal funds rate typically becomes <i>negative prior</i>to the onset of a recession. The exception to this was the recession that commenced in Q2:1960. Although the yield spread narrowed prior to the onset of this recession, it did not turn negative. In late 1966, the yield spread turned negative, but a recession did not occur. Although real gross domestic purchases did not contract, growth did slow precipitously. As I mentioned in a previous commentary, my former colleague at the Chicago Fed, <a href="https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwi0st286Z_cAhULMawKHbhbAA0QFggzMAE&url=https%3A%2F%2Fwww.chicagofed.org%2F~%2Fmedia%2Fpublications%2Feconomic-perspectives%2F1988%2Fep-jan-feb1988-part1-laurent-pdf.pdf&usg=AOvVaw0Hu11GjGcW0klYEzje0H62" style="color: purple;">Robert D. Laurent</a>, did seminal research on the <i>leading</i>-indicator characteristic of the behavior of the yield curve. Rest in peace, Bob.</div>
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Chart 1<o:p></o:p></div>
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There is reason to believe that there is <i>causality</i>between the behavior of the yield spread and the behavior of real domestic demand. The federal funds rate is the overnight interest rate on cash reserves traded among depository institutions (banks). The Fed controls the <i>supply</i>of these reserves. To paraphrase the poet Joyce Kilmer, only the Fed can make reserves. Like any other price, the federal funds rate is determined by the interaction of the demand for reserves by banks and the supply of reserves controlled by the Fed. The Fed determines the level of the federal funds rate by altering the <i>supply</i>of reserves relative to the <i>demand</i>for reserves. If the demand for reserves should fall, all else the same, the federal funds rate would also fall. But if the Fed is targeting a particular level of the federal funds rate, the Fed would then reduce the supply of reserves to prevent the federal funds rate from continuing to trade at the lower level. (It is left as an exercise for the reader to explain what the Fed would do if the demand for reserves were to increase such that the federal funds rate were to rise above the Fed’s target level.)<o:p></o:p></div>
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Although the federal funds rate is determined by the Fed, the Fed’s influence on the levels of other interest rates free from credit risk is inversely related to the maturity of the interest-bearing security. The Fed attempts to signal its near-term intentions with regard to the level of the federal funds rate. For example, since its hike in the federal funds rate on June 13, 2018, the Fed has made known its intention to raise the federal funds an additional 0.25 of a percentage point on September 26, 2018. With less certainty, the Fed also has indicated that it will raise the federal funds another 0.25 of a percentage point on December 19, 2018. So, back in mid-June 2018, the yield on six-month maturity Treasury securities reflected expectations of an approximate cumulative increase in the federal funds rate of 0.50 of a percentage point by the end of 2018. But the Fed’s certainty as to how it will move the level of the federal funds rate wanes the farther into the future it peers. Financial market participants implicitly understand the Fed’s uncertainty as to how it intends to move the federal funds rate farther in the future and incorporate this uncertainty in their federal funds rate expectations. Therefore, future Fed intentions with regard to the level of the federal funds rate have minimal influence on the level of the yield on the Treasury 10-year security. <o:p></o:p></div>
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Suppose the Fed starts raising the federal funds rate. In order to effect (spell check tried to change the “e” to an “a”) the increase in the federal funds rate, the Fed would have to slowdown the rate of increase in bank reserves. Because their marginal cost of funds has increased, banks would raise their loan rates. All else the same, the increase in bank loan rates would cause the quantity of bank credit demanded to slow. But suppose all else is not the same. Suppose that after a series of increases in the federal funds rate, businesses get more pessimistic about the demand for their product. This would induce them to slow down their demand for funds for the purchase of capital equipment. That is, the demand curve for credit would shift back. The fall in the demand for credit would put downward pressure on the structure of interest rates. Although the levels of interest rates on longer-maturity securities would fall, the federal funds rate is prohibited from falling because the Fed is assumed to have not lowered its federal funds target yet. So, a narrower spread between the yield on the Treasury 10-year security and the federal funds rate would result in a slowing in the growth of real domestic demand from a slowing in the quantity demanded of bank credit as a result of the increase in bank loan rates and an outright shift back in the demand for credit in general.<o:p></o:p></div>
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The slowing in the growth of real domestic demand <i>following</i>a narrowing in the yield spread was shown in Chart 1. Chart 2 shows the tendency for the growth in the sum of depository institution credit and depository institution reserves at the Fed, a variant of, you guessed it, thin-air credit, to also slow <i>after </i>the yield spread has narrowed.<o:p></o:p></div>
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Chart 2<o:p></o:p></div>
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Back to present. Although the yield curve is flattening, the U.S. economy in the aggregate shows no sign of flagging. But remember, the behavior of the yield curve is a <i>leading</i>indicator. There is one sector of the economy that typically begins to weaken before the aggregate economy does – housing. The data in Chart 3 illustrate that real residential investment (the red line) tends to<i>lead</i>the overall economy (the blue bars) into and out of recession. The data in Chart 4 suggest that currently both home sales and housing starts have begun to weaken.<o:p></o:p></div>
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Chart 3<o:p></o:p></div>
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Chart 4<o:p></o:p></div>
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The stock market also is thought to be a leading indicator. Currently, the U.S. stock market is at or near a cycle and all-time high. This phenomenon is <i>not </i>inconsistent with a flattening yield curve. Although the relationship between the behavior of the yield spread and the behavior of the stock market leaves a lot to be desired, the data in Chart 5 show that a narrowing yield spread tends to <i>lead</i>the decline in the stock market.<o:p></o:p></div>
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Chart 5<o:p></o:p></div>
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Discussions about the flattening yield curve abound of late. As a congenital contrarian, my primal instinct is to say that it is different this time. But from about 45 years of experience, I have come to realize that the phrase “it is different this time” represents the five most dangerous words in an economic forecaster’s lexicon. Perhaps a better guide for an economic forecaster is the translated French expression “the more things change, the more they stay the same”. Bob Laurent and I, mostly Bob, began doing research on the behavior of the yield curve in 1985 when I still was an economist at the Chicago Fed. In August 1986, I took a walk north on LaSalle Street to become an economist at The Northern Trust Company. Bob continued to do research on the yield curve and I continued to believe that he had found the Holy Grail of economic forecasting. The yield spread began to narrow with a vengeance in the second half of 1988, turning negative in Q1:1989 and remaining negative throughout the remainder of the year. As I recall, early in 1989 I started sounding the recession alarm. But the economy remained strong, much as it appears to be currently. Even though the Fed stopped raising the federal funds rate in mid 1989 and started cutting it in the second half of 1989, the yield on the Treasury 10-year security continued to decline and the yield spread remained negative. At the same time that the spread was narrowing and turning negative back then, the Treasury was cutting back on its issuance of longer-maturity securities. With no signs of a weakening economy and thinking that the lack of supply of longer-maturity Treasury securities might be the explanation for the continued decline in the yield on the Treasury 10-year security and the negative yield spread, I concluded that the signal being sent by the behavior of the yield spread was <i>different this time</i>. The recession started around midyear 1990! As I said, the five most dangerous words in an economic forecaster’s lexicon are “it is different this time”.<o:p></o:p></div>
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Unless the U.S. economy slows abruptly between now and the end of 2018 and/or unless some external economic or geopolitical crisis erupts that destabilizes financial markets, the Fed is likely to raise the federal funds rate a cumulative 0.50 of a percentage point by yearend. In all likelihood the spread between the yield on the Treasury 10-year security and the federal funds rate will narrow further from its week-ended August 31 level of 0.96 of a percentage point. Unless it is different this time, the Fed will have set the U.S. economy on a course for, at least, significantly slower real economic growth in 2019 and, at worst, a recession. In addition, the U.S. stock market is likely to perform considerably worse in 2019 than it has in 2018.<o:p></o:p></div>
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One of my former Chicago Fed colleagues, not Bob Laurent, used to joke that it was not too difficult to get paid two times your marginal revenue product, but three times was pushing it. Well, in my case, 3x0, 2x0, 1x0 – the answer is the same. It finally caught up with me. As much as I have enjoyed writing economic commentaries laced with data analysis, I have lost my access to the database of Haver Analytics unless I am willing to work for my marginal revenue product of zero. There are sources of free data, but nothing compares to Haver’s database in terms of user friendliness, timeliness and accuracy. So, this will be my final commentary. In the few sentient years I have left, I want to dedicate my time to my wonderful wife of 51 years, my children, my grandchildren, my friends, my community, music and sailing my 51-year old Pearson Commander sailboat on the sparkling waters of Green Bay. <o:p></o:p></div>
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I want to thank all of you that have read my economic rants through the years. I want to especially thank one of my readers and former Northern Trust colleague, Nick Shukas. I first met Nick when he was a back office trade checker with Northern Futures. Back office workers are the unsung heroes of financial institutions. Without them, the show cannot go on. I suppose that just because Nick is an intellectually curious person with broad interests, he started reading the daily comments I wrote for Northern Futures. When Northern Futures closed its doors and Nick transferred to another back office position within Northern, he still read my commentaries. I guess Nick’s a fool for punishment, but he continued to read my commentaries after I retired from Northern and would call me to discuss economic developments. So Nick, thank you and I hope you still call.<o:p></o:p></div>
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Lastly, I am indebted to the management of Legacy Private Trust Company of Neenah, Wisconsin for giving me the opportunity to keep engaging in economic research since my retirement from Northern Trust in the spring of 2012. It has been my privilege to work with the Legacy people whom I hold in the highest esteem for their ethical standards and their trust company expertise. I believe that Legacy’s portfolio management team has a sound and unique approach to investing and I would not hesitate to recommend their services to anyone. Econtrarian out.<o:p></o:p></div>
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Paul L. Kasriel<o:p></o:p></div>
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Founder, Econtrarian, LLC<o:p></o:p></div>
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<a href="https://www.blogger.com/null"><span style="font-family: "arial";">The Econtrarian</span></a><o:p></o:p></div>
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<a href="https://www.blogger.com/null"><span style="font-family: "arial";">econtrarian@gmail.com</span></a><u><span style="color: #103cc0;"><o:p></o:p></span></u></div>
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<u><span style="color: #103cc0;">1-920-559-0375<o:p></o:p></span></u></div>
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<b>“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte<o:p></o:p></b></div>
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<b>∆ + 6 = A Good Life<o:p></o:p></b></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-52114111450711817312018-07-23T09:25:00.001-07:002018-07-23T09:25:16.198-07:00One Simple Policy to Simultaneously Strengthen Your Currency and Weaken Your Exports<div align="right" class="MsoNoSpacing" style="font-family: Calibri; font-size: 11pt; margin: 0in 0in 0.0001pt; text-align: right;">
<a href="https://www.blogger.com/blogger.g?blogID=3399546775946309435" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"></a>July 23, 2018<o:p></o:p></div>
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<b><u>One Simple Policy to Simultaneously Strengthen Your Currency and Weaken Your Exports<o:p></o:p></u></b></div>
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If a policymaker wanted to simultaneously strengthen the foreign exchange value of a country’s currency and weaken the country’s exports, that policymaker would be advised to impose tariffs on the country’s imports. This is the policy prescription I gleaned from reading Dartmouth College Professor Douglas A. Irwin’s 30-page monograph, “<a href="http://www.aei.org/wp-content/uploads/2014/04/-three-simple-principles-of-trade-policy_142937157317.pdf" style="color: purple;">Three Simple Principles of Trade Policy</a>”. The three principles of trade policy discussed in this intellectually powerful and compact publication are: (1) a tax on imports is a tax on exports, (2) businesses are consumers too, and (3) trade imbalances reflect capital flows. I have previously discussed, albeit in a less eloquent way than Professor Irwin, his third principle in my March 5, 2018 commentary, “<a href="http://the-econtrarian.blogspot.com/2018/03/" style="color: purple;">The Expected Widening in the U.S. Federal Budget Deficit Has Trade Protectionist Implications</a>”. In this commentary, I want to present Professor Irwin’s first principle, again less eloquently than he.<o:p></o:p></div>
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Suppose that the U.S. government imposes tariffs on say, Chinese goods. This will increase the price of those Chinese goods on which tariffs are imposed. The quantity demanded by U.S. residents of these Chinese goods will decrease. This will lessen the demand for Chinese yuan in the foreign-exchange market because fewer Chinese goods are now being purchased by U.S. residents. The fall in the demand for Chinese yuan will cause its foreign-exchange value to depreciate vs. the U.S. dollar. Alternatively, the foreign-exchange value of the U.S. dollar will appreciate, or strengthen, vs. the Chinese yuan. So, one Chinese yuan will now purchase fewer U.S. dollars, making the yuan price of U.S.-produced goods higher. The appreciation of the U.S. dollar will cause the quantity-demanded by Chinese residents of U.S.-produced goods to decrease. So, the net results of the imposition of tariffs by economy’s policymaker will be to cause that economy’s currency to appreciate in the foreign-exchange market and to cause that economy’s exports to decrease.<o:p></o:p></div>
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Professor Irwin makes the argument that “[e]xports and imports are inherently interdependent, and any policy that reduces one will also reduce the other.” This suggests that an economy’s exports and imports should be positively and highly correlated. That is, if exports rise, so should imports. The chart below in which are plotted year-to-year dollar changes in the annual averages of nominal U.S. exports and imports from 1930 through 2017 contains data that are consistent with Professor Irwin’s argument. The correlation is positive between the dollar changes in U.S. exports and imports and its value is 0.92 out of a possible 1.00 high. <o:p></o:p></div>
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In sum, if a policymaker’s goal is to simultaneously strengthen an economy’s currency in the foreign-exchange market and decrease the economy’s exports, then, by all means, the policymaker should impose tariffs on imported goods.<o:p></o:p></div>
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Paul L. Kasriel<o:p></o:p></div>
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Founder, Econtrarian, LLC<o:p></o:p></div>
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<a href="https://www.blogger.com/null"><span style="font-family: Arial;">The Econtrarian</span></a><o:p></o:p></div>
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Senior Economic and Investment Advisor<o:p></o:p></div>
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<a href="http://www.lptrust.com/" style="color: purple;"><span style="color: #103cc0;">Legacy Private Trust Co., Neenah, WI</span></a><o:p></o:p></div>
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<a href="https://www.blogger.com/null"><span style="color: #103cc0;">econtrarian@gmail.com</span></a><o:p></o:p></div>
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<a href="https://www.blogger.com/null"><span style="color: #103cc0;">1-920-818-0236</span></a><u><span style="color: #103cc0;"><o:p></o:p></span></u></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-41354184299124937882018-07-16T18:33:00.001-07:002018-07-16T18:33:40.688-07:00Unless the Fed Changes Course, a 2019 Recession Collision Is the Most Likely Outcome<div align="right" class="MsoNoSpacing" style="font-family: Calibri; font-size: 11pt; margin: 0in 0in 0.0001pt; text-align: right;">
July 17, 2018<o:p></o:p></div>
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<b><u>Unless the Fed Changes Course, a 2019 Recession Collision Is the Most Likely Outcome<o:p></o:p></u></b></div>
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The current level of the federal funds rate is 1.92%. As of June 13, 2018, the median estimate of Federal Open Market Committee (FOMC) members of the appropriate federal funds rate by the end of 2081 was 2.40%. This implies that the Federal Reserve has “penciled in” two more 25 basis point increases by the end of this year. If, in fact, the Fed holds this rate-increase course, I believe a recession will occur sometime in 2019. How do I know? The yield curve tells me so.<o:p></o:p></div>
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Cast your eyes on Chart 1, which shows you the behavior of the quarterly average percentage point spread between the yields on a 10-year Treasury security and 1-year Treasury security from January 1955 through June 2018. The shaded areas in Chart 1 represent periods of recession. Notice that every recession starting with the 1957-58 recession was <i>preceded</i>by a <i>narrowing</i>in this yield spread to a degree that the value of the spread went <i>negative</i>. That is every recession starting with the 1957-58 one was <i>preceded</i>a <i>negative</i>spread between the yield on the Treasury 10-year security and the Treasury 1-year security. During the January 1955 through June 2018 period, there was <i>only one</i>occasion when this negative yield spread gave an incorrect recession signal. That was from December 1965 through February 1967. During this period, the pace of real economic activity slowed sharply, but not sharply enough or long enough to result in being designated a recession by the arbiters of such, the National Bureau of Economic Research. To wit, in the four quarters ended Q2:1967, real GDP grew by 2.6%, down from 7.5% in the four quarters ended Q2:1966. As economic growth weakened, the Fed shepherded the federal funds rate down from 5.75% in December 1966 to 3.50% by June 1967, thus pulling the economy out of its nosedive. As of July 13, 2018, this yield spread stood at 0.48 percentage points. If the Fed were to hike the funds rate another 0.50 percentage points by yearend, the yield on the Treasury 1-year security were to rise by the same amount and the yield on the Treasury 10-year security were to remain the same, the Treasury 10-year – 1-year yield spread would move into negative territory.<o:p></o:p></div>
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Chart 1<o:p></o:p></div>
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The seminal and best research on the yield spread as an indicator of monetary policy and as a predictor of recessions was done by the Nikola Tesla of monetary economics, the deeply missed <a href="https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwi0st286Z_cAhULMawKHbhbAA0QFggzMAE&url=https%3A%2F%2Fwww.chicagofed.org%2F~%2Fmedia%2Fpublications%2Feconomic-perspectives%2F1988%2Fep-jan-feb1988-part1-laurent-pdf.pdf&usg=AOvVaw0Hu11GjGcW0klYEzje0H62" style="color: purple;">Robert D. Laurent</a>. The logic behind the yield spread as an indicator of the degree of restrictiveness or accommodation of monetary policy is as follows. Assume that the Fed raises the federal funds rate in an environment in which the overall demand for credit is unchanged. In order to push the federal funds rate higher, the Fed has to reduce the supply of reserves (part of the monetary base) relative to the demand for reserves. So, all else the same, an increase in the federal funds rate entails a slowdown in the growth of the monetary base. Recall that the monetary base is – get ready – a component of <i>thin-air </i>credit. Ding! Ding! Ding! The federal funds rate is the base interest rate at which banks can obtain funds. As this base funding rate rises, banks will be induced to raise the interest rates at which they will loan funds. As bank loan interest rates rise, the quantity demanded of bank credit will decline. And what is the other and biggest component of thin-air credit? Bank credit. So, a Fed-induced rise in short-maturity interest rates relative to longer-maturity interest rates will lead to a slowdown in the growth of thin-air credit, which implies a slowdown in the growth of aggregate spending. Ah, the circle is completed. This is illustrated in Chart 2 in which is plotted the quarter-to-quarter annualized percent change in the sum of commercial bank credit and the monetary base vs. the quarterly average yield spread in percentage points between the Treasury 10-year security and the Treasury 1-year security. Notice that as the yield spread has been narrowing since 2014, growth in thin-air credit has been slowing.<o:p></o:p></div>
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Chart 2<o:p></o:p></div>
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But how can I be talking about a recession in 2019 when the economy seems to be bursting at its seams now? The Atlanta Fed’s Q2:2018 real GDP annualized growth forecast as of July 16 was a whopping 4.5%. If second quarter real GDP growth were, in fact, to turn out to be 4.5%, this would represent the fastest quarter-to-quarter growth in real GDP the world has ever seen – that is, since the 5.2% growth in the third quarter of 2014 when you know who was president. Just as pride goeth before the fall, <i>coincident </i>indicators go up before a recession. In the past nine NBER business cycles, only three expansion peak quarters exhibited a contraction in real GDP. The largest peak-quarter real GDP growth was 4.7% (Q3:1981). The largest peak-quarter contraction was -1.7%. I suggest this country and western song title for economic forecasters – “How You Gonna See the Turn in the Road if You Keep Lookin’ Out the Side Window?”<o:p></o:p></div>
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With the real economy currently booming and the rate of consumer inflation trending higher, the Fed, in all likelihood, will not be able to constrain itself from raising the federal funds rate another 25 basis points at the end of its September 25-26 meeting. If the Fed holds its fire thereafter, the U.S. economy just might be able to avoid a 2019 recession, although real economic growth will have slowed to a crawl. If the Fed goes ahead an raises the federal funds an additional 25 basis at its December 18-19 meeting, batten down the recession hatches in 2019. <o:p></o:p></div>
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Paul L. Kasriel<o:p></o:p></div>
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Founder, Econtrarian, LLC<o:p></o:p></div>
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<a href="https://www.blogger.com/null"><span style="font-family: Arial;">The Econtrarian</span></a><o:p></o:p></div>
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Senior Economic and Investment Advisor<o:p></o:p></div>
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<a href="http://www.lptrust.com/" style="color: purple;"><span style="color: #103cc0;">Legacy Private Trust Co., Neenah, WI</span></a><o:p></o:p></div>
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<a href="https://www.blogger.com/null"><span style="color: #103cc0;">econtrarian@gmail.com</span></a><o:p></o:p></div>
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<a href="https://www.blogger.com/null"><span style="color: #103cc0;">1-920-818-0236</span></a><u><span style="color: #103cc0;"><o:p></o:p></span></u></div>
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<b>“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte<o:p></o:p></b></div>
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<b>∆ + 6 = A Good Life</b><o:p></o:p></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-66896351551675907452018-07-02T10:25:00.000-07:002018-07-02T10:25:12.655-07:00Our Exploding National Debt: What, Me Worry?<div class="separator" style="clear: both; text-align: center;">
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<br />Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-73113867525476651832018-04-16T18:23:00.000-07:002018-04-16T18:23:11.895-07:00Thin-Air Credit Growth Slowdown Augurs Poorly for 2018 Domestic Demand Growth<div align="right" class="MsoNoSpacing" style="text-align: right;">
April 16, 2018<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<b style="mso-bidi-font-weight: normal;"><u>Thin-Air Credit Growth Slowdown Augurs
Poorly for 2018 Domestic Demand Growth<o:p></o:p></u></b></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div class="MsoNoSpacing">
A majority of my readers (two) have asked me to update
the discussion about the behavior of thin-air credit or a variant thereof,
namely the sum of commercial bank credit (loans and securities) and the
monetary base (bank reserves at the Fed and currency). To paraphrase the motto
of the former iconic Chicago department store, Marshall Field’s, give the
customers what they want. To give the “customers” a preview of what they are
going to get, let me state that thin-air credit growth has slowed to a rate
that is low both from a long-run and short-run perspective. The slowing growth
in <i style="mso-bidi-font-style: normal;">nominal</i> thin-air credit in
conjunction with the acceleration in consumer price inflation has negative
implications for growth in real U.S. aggregate domestic demand in 2018. In
turn, if growth in real aggregate domestic demand “surprises” on the downside
in 2018, then the Fed is unlikely to hike the federal funds rate the full 50
basis points this year that the market currently expects. Alternatively, if the
Fed is hell-bent on raising the federal funds rate 50 basis points or more over
the remainder of 2018, it would be sowing the seeds of a 2019 recession unless
there is an acceleration in the growth of nominal and real thin-air credit. An
acceleration in the growth of thin-air credit would be unlikely in the face of
a rising federal funds rate.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
As shown in Chart 1, year-over-year growth in thin-air
credit has trended lower from its 9+ percent observations from Q4:2013 through
Q3:2014. As of Q1:2018, year-over-year growth in thin-air credit was 2.7% --
low growth in terms both of a long-run and short-run historical perspectives.<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 1<o:p></o:p></div>
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<a href="https://1.bp.blogspot.com/-P90HsqaePyE/WtVLxcxcdAI/AAAAAAAABUQ/HXOu6QcR1n0raVif2tCnT87ue_C5B53ewCLcBGAs/s1600/Thin%2BAir%2BCredit%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="732" data-original-width="975" height="480" src="https://1.bp.blogspot.com/-P90HsqaePyE/WtVLxcxcdAI/AAAAAAAABUQ/HXOu6QcR1n0raVif2tCnT87ue_C5B53ewCLcBGAs/s640/Thin%2BAir%2BCredit%2BChart%2B1.png" width="640" /></a></div>
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<div class="MsoNoSpacing">
Plotted in Chart 2 are the year-over-year percent changes
in the quarterly observations of, again, thin-air credit (the sum of commercial
bank credit and the monetary base) along with the percent changes in each of
its major components – commercial bank credit and the monetary base – by
themselves. The slowing growth in thin-air credit (the red line) in 2015 and
2016 was primarily due to the Fed’s cessation of quantitative easing (QE),
i.e., large outright purchases of government securities and quasi-government
mortgage-backed securities, which resulted in the year-over-year contractions
in the monetary base (the green bars). Surprisingly, at least so to me, was the
rebound in year-over-year growth in the monetary base in the past three
quarters inasmuch as the Fed had started to reduce, albeit marginally, its
outright holdings of securities and the Fed had been hiking the federal funds
rate. Starting in 2017 and continuing through the first quarter of 2018, growth
in commercial bank credit the blue line) has been trending lower, which has
restrained the growth in thin-air credit.<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 2<o:p></o:p></div>
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<a href="https://4.bp.blogspot.com/-ngna-lfxZNo/WtVL6t5vfhI/AAAAAAAABUU/Eexz6twWBE4BsXPCupzJHwJeX4Ecup_8ACLcBGAs/s1600/Thin%2BAir%2BCredit%2BChart%2B2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="732" data-original-width="975" height="480" src="https://4.bp.blogspot.com/-ngna-lfxZNo/WtVL6t5vfhI/AAAAAAAABUU/Eexz6twWBE4BsXPCupzJHwJeX4Ecup_8ACLcBGAs/s640/Thin%2BAir%2BCredit%2BChart%2B2.png" width="640" /></a></div>
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<div class="MsoNoSpacing" style="text-align: justify;">
Not only has growth in <i style="mso-bidi-font-style: normal;">nominal</i> thin-air credit slowed, but so,
too, has growth in <i style="mso-bidi-font-style: normal;">real</i> thin-air
credit, i.e., nominal thin-air credit deflated by the Consumer Price Index
(CPI). In Q1:2018, the year-over-year percent change in real thin-air credit
was just 0.5%. The importance of this is that there is a relatively high
correlation between the year-over-year growth in real thin-air credit and real
final sales to domestic purchasers. Starting in Q1:2011, the correlation coefficient
between the year-over-year percent changes in real final sales to domestic
purchasers and the year-over-year percent changes in real thin-air credit, <i style="mso-bidi-font-style: normal;">advanced two quarters</i>, is 0.68 out of
maximum possible 1.00. This is shown in Chart 3. <o:p></o:p></div>
<div class="MsoNoSpacing" style="text-align: justify;">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 3<o:p></o:p></div>
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<a href="https://2.bp.blogspot.com/-_8sAIiy1CUk/WtVMDgZQK1I/AAAAAAAABUY/YcKB0kJFDyQkBd23uFzViNHu3AxUTS1YwCLcBGAs/s1600/Thin%2BAir%2BCredit%2BChart%2B3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="475" data-original-width="975" height="310" src="https://2.bp.blogspot.com/-_8sAIiy1CUk/WtVMDgZQK1I/AAAAAAAABUY/YcKB0kJFDyQkBd23uFzViNHu3AxUTS1YwCLcBGAs/s640/Thin%2BAir%2BCredit%2BChart%2B3.png" width="640" /></a></div>
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<span style="mso-no-proof: yes;"><!--[if gte vml 1]><v:shape id="Picture_x0020_4"
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<div class="MsoNoSpacing" style="text-align: justify;">
As one of my readers (the
other one?) has correctly pointed out, correlation does not necessarily imply
causation. However, when I tested the lead-lag relationships between these two
series, I found that the correlation coefficient was highest when thin-air
credit growth <i style="mso-bidi-font-style: normal;">leads</i> growth in real
final sales to domestic purchasers by two quarters. When growth in real final
sales to domestic purchasers <i style="mso-bidi-font-style: normal;">leads</i>
growth in real thin-air credit, the correlation coefficient <i style="mso-bidi-font-style: normal;">declines. </i>This does <i style="mso-bidi-font-style: normal;">not</i> <i style="mso-bidi-font-style: normal;">prove</i> that growth in
thin-air credit <i style="mso-bidi-font-style: normal;">causes </i>growth in real
final sales to domestic purchasers, but it sure does support the hypothesis.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
In sum, the slowing in the growth of both nominal and
real thin-air credit augurs poorly for the growth in aggregate domestic demand
in 2018. But wait, won’t this year’s federal tax cuts stimulate demand? Not
unless the resulting increased deficits are financed with the creation of
thin-air credit. (See my January 22, 2018 blog post “<a href="http://the-econtrarian.blogspot.com/2018/01/">No Sugar High from Tax Cut
Unless the Fed and the Banking System Provide the Sugar</a>” for an explanation
of this). And, so far, at least, growth in thin-air credit has slowed, not
accelerated. The market currently expects the Fed to hike the federal funds rate
at least another 50 basis points this year. If I am right that growth in
domestic demand slows this year, a further 50 basis point increase in federal
funds rate might be sowing the seeds of 2019 recession. Available data, such as
annualized growth in Q1:2018 nominal retail sales of 0.8% vs. 10.4% in Q4:2017,
suggest a slowing in the growth of Q1:2018 final sales. Rumor has it that the
Fed believes this slowing in aggregate demand growth is mainly due to “faulty”
seasonal adjustment factors. The Fed ought to take a look at the behavior of
thin-air credit growth before dismissing the weakness in first quarter final
sales growth.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel, Founder, Econtrarian, LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="https://www.blogger.com/Downloads/the-econtrarian.blogspot.com">The
Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Co., Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="file:///tel/1-920-818-0236">1-920-818-0236</a><u><o:p></o:p></u></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swart<span style="mso-spacerun: yes;"> </span>∆ +
6 = A Good Life<o:p></o:p></b></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-32262591282059393992018-04-01T14:11:00.002-07:002018-04-01T14:11:57.027-07:00As of this Past Fourth Quarter, the S&P 500 Remained Relatively Cheap<div align="right" class="MsoNoSpacing" style="text-align: right;">
April 2, 2018<o:p></o:p></div>
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<br /></div>
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<b style="mso-bidi-font-weight: normal;"><u>As of this Past Fourth Quarter, the
S&P 500 Remained <i style="mso-bidi-font-style: normal;">Relatively</i> Cheap<o:p></o:p></u></b></div>
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<br /></div>
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Now that the first quarter of 2018 has just ended, what could
be more fitting than to look back at the relative valuation of the S&P 500
stock index as of last year’s fourth quarter? After all, isn’t that what we
economists do best, look <i style="mso-bidi-font-style: normal;">back</i>? This
commentary is an update to my November 29, 2017 commentary, “<a href="http://the-econtrarian.blogspot.com/2017/11/">The S&P 500 Is Not
Expensive According to the Kasriel Valuation Model</a>”. Before reviewing my
methodology for estimating the over/under valuation of the S&P 500 stock
market index, let me give you the Q4:2017 results upfront. According to my
methodology, the S&P 500 index in Q4:2017 was overvalued by 7.4% compared
with a revised 4.1% overvaluation in Q3:2017. Given that the median value of
over/under valuation of my methodology in the period Q1:1964 through Q4:2017
was 35.5% overvaluation, the 7.4% overvaluation of the S&P 500 in Q4:2017
seems trivial. The continued low level of the corporate bond yield is the
principal factor keeping the S&P 500 from being more materially overvalued.
<span style="mso-spacerun: yes;"> </span>Now for the important disclaimer. My
relative valuation methodology involves only three observable variables –
smoothed annualized reported earnings of corporations included in the S&P
500 equity index, the level of the corporate BAA/A-BBB bond yield and the
actual market capitalization of the S&P 500. My methodology does <i style="mso-bidi-font-style: normal;">not</i> take into consideration <i style="mso-bidi-font-style: normal;">expectations </i>of corporate earnings or of
bond yields. Nor does it take into consideration exogenous “shocks” including
but not restricted to the likelihood of changes in the U.S. tax code, of geopolitical
conflicts or of the imposition of U.S. trade protectionist policies. Of course,
if I had a high degree of certainty about these exceptions to my “model”, I would
be an extremely wealthy person and would not be inclined to share my “wisdom”
with you!<o:p></o:p></div>
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To refresh your memory about my methodology, I calculate
a quarterly <i style="mso-bidi-font-style: normal;">theoretical </i>market
capitalization for the S&P 500 by discounting (dividing) <i style="mso-bidi-font-style: normal;">smoothed</i> annualized reported earnings of
S&P 500 corporations by the yield on the lowest-rate <i style="mso-bidi-font-style: normal;">investment</i>-grade corporate bonds (BAA/A-BBB). I then compare my
calculated theoretical market capitalization value with the <i style="mso-bidi-font-style: normal;">actual</i> market capitalization value. The
percent of over/under value for the S&P 500 is calculated as follows:<o:p></o:p></div>
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<br /></div>
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((Actual Market
Cap/Theoretical Market Cap)-1)*100<o:p></o:p></div>
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<br /></div>
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The technique I use to <i style="mso-bidi-font-style: normal;">smooth</i> reported corporate earnings is some high-falutin’
econometric technique called the Hodrick-Prescott filter. (Edward Prescott is a
Nobel Prize winner in economics.) This smoothing technique is designed to
remove the cyclical variation from a trending series. Another economics Nobel
Prize winner, Robert Shiller, uses a 10-year moving average to smooth the
S&P 500 price-to-earnings ratio in his stock market valuation research. He
calls this the <i style="mso-bidi-font-style: normal;">cyclically</i>-adjusted
P/E. It seems to me that a 10-year moving average is an arbitrary tool to use
to remove the cyclical component from a time series. Why not use a technique
specifically designed to remove cyclicality? While I’m on the subject of the
Shiller cyclically-adjusted P/E, aside from the arbitrariness of using a
10-year moving average, a P/E <i style="mso-bidi-font-style: normal;">in
isolation</i> tells you nothing about the stock market’s over/under valuation
without taking into consideration the level of bond yields. A low P/E could be
an indication of an overvalued stock market if the bond yield is relatively
high. Conversely, a high P/E could be an indication of an undervalued stock
market if the bond yield were relatively low, as has been the case for several
years now. <o:p></o:p></div>
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Let’s go to the data. Plotted in the chart below are the
quarterly observations of the percent over(+)/under(-) valuation of the S&P
500 calculated with my methodology discussed above. Also plotted in the chart
are quarterly observations of the year-over-year percent change in the S&P
500 equity index. If my methodology has any legitimacy, there should be a negative
correlation between the over/under valuation variable and the year-over-year
percent change in the S&P 500 index. That is, if the S&P 500 is
overvalued as calculated by methodology, then I would expect the S&P 500
equity index to be increasing at a slower rate or even declining. I found that
the highest <i style="mso-bidi-font-style: normal;">absolute </i>value of a <i style="mso-bidi-font-style: normal;">negative</i> correlation coefficient, minus
0.20, is obtained when the over/under valuation is <i style="mso-bidi-font-style: normal;">advanced</i> <i style="mso-bidi-font-style: normal;">by five quarters</i>
in relation to the year-over-year percent change in the S&P 500 index. <span style="mso-spacerun: yes;"> </span>(With the low value of the correlation
coefficient at minus 0.20, there obviously is a lot missing from this “model”
in terms of explaining the behavior of the stock market, as I admitted at the
outset.) So, the last data point plotted in the chart for the over/under
valuation variable at Q1:2019 is actually the observation for Q4:2017 (advanced
five quarters). The median value of over/under valuation is 35.5%. So,
interpreting whether the S&P 500 is over or undervalued, it is better to
look at the percent over/under valued in terms of 35.5% rather than zero.<o:p></o:p></div>
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As of Q4:2017, then, <span style="mso-spacerun: yes;"> </span>my “model” indicated that the S&P 500 was
overvalued by 7.4% -- a relatively low reading in comparison to the 35.5%
median value for over/under valuation during the entire sample period. The
yield on the BAAA-BBB corporate bond yield appears to have averaged about 4.45%
in Q1:2018, up about 18 basis points from its Q4:2017 level. The market cap of
the S&P 500 was about $22.5 trillion. If annualized smoothed S&P 500
reported earnings remained at their Q4:2017 level of $906.7 billion, then the
S&P 500 would be 10.4% overvalued in Q1:2018 – still well below the median
overvaluation of 35.5%. What if the BAA corporate bond yield had risen 100
basis points in Q1:2018 to a level of 5.27% and annualized smoothed reported
S&P 500 earnings remained the same as they were in Q4:2017. In this case,
in relation to the actual S&P market cap in Q1:2018, the S&P 500 would
have been <i style="mso-bidi-font-style: normal;">31%</i> overvalued. Of course,
if the bond yield had risen by 100 basis point in Q1:2017, it is likely the
actual S&P 500 market cap would have been significantly lower, and thus,
the overvaluation of the market would also have been lower.<o:p></o:p></div>
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In sum, given S&P 500 annualized smoothed reported
earnings and the current level of corporate bond yields, the S&P 500 stock
market does not appear to be excessively overvalued. The continued low level of
corporate bond yields is the principal reason that the overvaluation of the
S&P 500 remains low in an historical context. Corporate earnings are
growing, but at a subdued pace. In full disclosure, my portfolio is devoid of
equities even though I do not believe that the S&P 500 is grossly
overvalued. <span style="mso-spacerun: yes;"> </span>Why? Because of those other
factors that I mentioned earlier in this commentary. As evidenced by the quote
I put at the end of my commentaries -- <i style="mso-bidi-font-style: normal;">for
most of human history, it made good adaptive sense to be fearful and emphasize
the negative; any mistake could be fatal</i> – I am congenitally risk averse.
The S&P 500 equity index exhibited increased volatility in Q1:2018. I
believe that this increased volatility was due primarily to exogenous “shocks”
mentioned earlier in this commentary rather than the behavior of corporate
earnings and/or corporate bond yields.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian, LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="https://www.blogger.com/the-econtrarian.blogspot.com">The Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Co., Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="file:///tel/1-920-818-0236">1-920-818-0236</a><u><o:p></o:p></u></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte<o:p></o:p></b></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">∆ + 6 = A Good
Life</b><u><o:p></o:p></u></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-71933603550790857992018-03-05T14:10:00.001-08:002018-03-05T14:14:55.187-08:00The Expected Widening in the U.S. Federal Budget Deficit Has Trade Protectionist Implications <div align="right" class="MsoNoSpacing" style="text-align: right;">
March 5, 2018<o:p></o:p></div>
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<br /></div>
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<b style="mso-bidi-font-weight: normal;"><u>The Expected Widening in the U.S.
Federal Budget Deficit Has Trade Protectionist Implications <o:p></o:p></u></b></div>
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<br /></div>
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With the recent U.S. congressional passing and
presidential signing of the Tax Cuts and Jobs Act of 2017 and the Bipartisan
Budget Act of 2018, the federal budget deficit is projected to increase in the
next few years. According to projections by the nonpartisan <a href="http://www.crfb.org/papers/updating-us-budget-outlook">Committee for a
Responsible Federal Budget</a>, the U.S. federal budget will rise from $665
billion in fiscal year (FY) 2017 to $753 billion in FY 2018 and $1.1 <i style="mso-bidi-font-style: normal;">trillion</i> in FY 2019. Unless these
increased federal budget deficits are financed out of increased U.S domestic
saving, they imply increased financing from the rest of the world. Increased
lending to the U.S. from the rest of the world implies a widening U.S. trade
deficit. President Trump appears to have viewed the persistent U.S. trade
deficit a result of “unfair” trade practices on the part of some U.S. trading
partners. (I presented a counter argument to this view in my November 17, 2017
commentary entitled <o:p></o:p></div>
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“<a href="http://the-econtrarian.blogspot.com/2017/11/at-least-we-can-be-thankful-for-11-fair.html">At
Least We Can Be Thankful to the ‘11’ Fair Traders</a>”.) The Trump
administration has imposed import tariffs on solar panels and washing machines
recently and has announced its intention to impose import tariffs on steel and
aluminum because of perceived unfair trade practices on the part of trading
partners. If past is prologue, a widening in U.S. trade deficits resulting from
widening U.S. federal budget deficits in the next couple of years could trigger
more protectionist actions by the Trump administration.<o:p></o:p></div>
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<br /></div>
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Let’s look at some data to build a case that U.S. federal
budget deficits are related to U.S. trade deficits. Plotted in Chart 1 are
annual observations of U.S.<i style="mso-bidi-font-style: normal;"> net</i>
exports of goods and services from 1970 through 2017. Net exports are exports
minus imports. So, if net exports are negative, it means that the value of
goods and services imported by a country are is greater than the value of its
exports. If net exports are negative, it means that a country is running a
trade deficit. The data in Chart 1 show that the U.S. has consistently been
running trade deficits from 1976 through 2017.<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<b style="mso-bidi-font-weight: normal;">Chart 1<o:p></o:p></b></div>
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<a href="https://4.bp.blogspot.com/-P8w8HgDXcIU/Wp2_oM9qRyI/AAAAAAAABRs/IUI3Epsybi8wgrsFo-9isemX-UJZyHoeQCEwYBhgL/s1600/Budget%2Btrade%2Bdeficit%2Bchart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="611" data-original-width="975" height="400" src="https://4.bp.blogspot.com/-P8w8HgDXcIU/Wp2_oM9qRyI/AAAAAAAABRs/IUI3Epsybi8wgrsFo-9isemX-UJZyHoeQCEwYBhgL/s640/Budget%2Btrade%2Bdeficit%2Bchart%2B1.png" width="640" /></a></div>
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When a country runs a trade deficit, it means that the
residents of that country are spending more on goods and services than they are
producing. To see this, let’s look at the identity for GDP:<o:p></o:p></div>
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<br /></div>
<div align="center" class="MsoNoSpacing" style="margin-left: .5in; mso-list: l0 level1 lfo1; text-align: center; text-indent: -.25in;">
<!--[if !supportLists]--><span style="mso-bidi-font-family: Calibri; mso-bidi-theme-font: minor-latin;"><span style="mso-list: Ignore;">(1)<span style="font: 7.0pt "Times New Roman";">
</span></span></span><!--[endif]-->GDP = Goods & Services Spending + (Exports –
Imports)<o:p></o:p></div>
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<br /></div>
<div class="MsoNoSpacing">
GDP is the value of goods and services <i style="mso-bidi-font-style: normal;">produced</i> in an economy. Goods and Services
Spending is the aggregate spending by households, businesses and government
entities.<span style="mso-spacerun: yes;"> </span><span style="mso-spacerun: yes;"> </span>Imports enter the GDP identity with a negative
sign in order to avoid double counting. That is, imports account for some of
the Goods & Services Spending.<span style="mso-spacerun: yes;">
</span>Because GDP represents the value of goods and services <i style="mso-bidi-font-style: normal;">produced </i>in an economy, imports need to
be subtracted from Goods & Services Spending. Because exports are not part
of domestic Goods & Services Spending but <i style="mso-bidi-font-style: normal;">are produced </i>in the economy, exports are added to Goods &
Services Spending. <o:p></o:p></div>
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By rearranging the terms in identity (1), we get:<o:p></o:p></div>
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<br /></div>
<div align="center" class="MsoNoSpacing" style="margin-left: .5in; mso-list: l0 level1 lfo1; text-align: center; text-indent: -.25in;">
<!--[if !supportLists]--><span style="mso-bidi-font-family: Calibri; mso-bidi-theme-font: minor-latin;"><span style="mso-list: Ignore;">(2)<span style="font: 7.0pt "Times New Roman";">
</span></span></span><!--[endif]-->GDP – Goods & Services Spending = (Exports –
Imports)<o:p></o:p></div>
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If the term (Exports – Imports) is negative, that is, a
country is running a trade deficit (<i style="mso-bidi-font-style: normal;">net </i>exports
are negative), then GDP minus Goods & Services Spending also must be
negative.<span style="mso-spacerun: yes;"> </span>So, a country that is running
a trade deficit, by definition, is spending more on goods and services than it
is producing. The only way a country can spend more on goods and services than
it produces is to receive goods and services from other countries. Unless the
residents of those countries providing goods and services to the country
running a trade deficit are gifting those goods and services, the residents of
the trade-deficit- running country are either incurring debt or are selling off
assets to the residents of the country providing the goods and services.<b style="mso-bidi-font-weight: normal;"> In sum, a country running a trade deficit
is, in effect, a net borrower from the rest of the world.<o:p></o:p></b></div>
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<br /></div>
<div class="MsoNoSpacing">
Plotted in Chart 2 are annual observations of U.S. net
exports, the same as in Chart 1. But also plotted are the annual observations
of net financial lending or borrowing by the combined U.S. nonfinancial sectors
– households, nonfinancial business and government entities. The positive
correlation between these two series for the period 1970 through 2016 is 0.81
(looks like 0.61 in Chart 2, but is 0.81). Recall, if the correlation were
“perfect”, its value would be 1.00. So, the data in Chart 2 are supportive of
the notion that as a country runs a wider trade deficit, its net financial
borrowing increases, too.<o:p></o:p></div>
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<b style="mso-bidi-font-weight: normal;">Chart 2<o:p></o:p></b></div>
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<a href="https://1.bp.blogspot.com/-ktg68qTQE7s/Wp2_4Clg1eI/AAAAAAAABRw/ejyE8eyhM344vaRTOVuubPMOMJHk-iaPQCLcBGAs/s1600/Budget%2BTrade%2BDeficit%2BChart%2B2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="397" data-original-width="975" height="260" src="https://1.bp.blogspot.com/-ktg68qTQE7s/Wp2_4Clg1eI/AAAAAAAABRw/ejyE8eyhM344vaRTOVuubPMOMJHk-iaPQCLcBGAs/s640/Budget%2BTrade%2BDeficit%2BChart%2B2.png" width="640" /></a></div>
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<div class="MsoNoSpacing">
Chart 3 shows from whom most of the borrowing comes when
the U.S. runs a trade deficit – the rest of the world, obviously. The <i style="mso-bidi-font-style: normal;">negative</i> correlation between U.S.
nonfinancial sector net borrowing and the rest of the world’s net lending to
the U.S. is minus 0.78 for the years 1970 through 2016.<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<b style="mso-bidi-font-weight: normal;">Chart 3<o:p></o:p></b></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://1.bp.blogspot.com/-zqmkYHBYlXk/Wp3AAn1EdeI/AAAAAAAABR0/BVY-GwmW3KEhOeoY5An0LyBBKiRpShPRgCLcBGAs/s1600/Budget%2BDeficit%2BTrade%2BDeficit%2BChart%2B3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="732" data-original-width="975" height="480" src="https://1.bp.blogspot.com/-zqmkYHBYlXk/Wp3AAn1EdeI/AAAAAAAABR0/BVY-GwmW3KEhOeoY5An0LyBBKiRpShPRgCLcBGAs/s640/Budget%2BDeficit%2BTrade%2BDeficit%2BChart%2B3.png" width="640" /></a></div>
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<div class="MsoNoSpacing">
Okay, what does all this have to do with widening U.S.
federal government budget deficits resulting in wider U.S. trade deficits? The
data in Chart 4 have a bearing on this question. Plotted in Chart 4 are annual
observations of net lending/net borrowing of the entire U.S. nonfinancial
sector, including the federal government sector, and the net lending/net
borrowing of the federal government sector by itself. The correlation between
these two series is a positive 0.64. This suggests that the federal government
budget deficit plays an important role as to whether the entire nonfinancial
sector is in a net lending or net borrowing position. And again, if the entire
nonfinancial sector is in a net borrowing position, there is a high probability
that the U.S will be running a trade deficit, with the magnitude of the trade
deficit positively correlated with the magnitude of the net borrowing position
of the nonfinancial sector, as shown in Chart 2.<o:p></o:p></div>
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<br /></div>
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<b style="mso-bidi-font-weight: normal;">Chart 4<o:p></o:p></b></div>
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<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://2.bp.blogspot.com/-i8BsVt4mtpc/Wp3AKbENtiI/AAAAAAAABR8/vefIaHMbiRwurjSkSxYNCQNh16WYJKxygCLcBGAs/s1600/Budget%2BDeficit%2BTrade%2BDeficit%2BChart%2B4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="408" data-original-width="975" height="266" src="https://2.bp.blogspot.com/-i8BsVt4mtpc/Wp3AKbENtiI/AAAAAAAABR8/vefIaHMbiRwurjSkSxYNCQNh16WYJKxygCLcBGAs/s640/Budget%2BDeficit%2BTrade%2BDeficit%2BChart%2B4.png" width="640" /></a></div>
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id="Picture_x0020_11" o:spid="_x0000_i1025" type="#_x0000_t75" style='width:468pt;
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<br /></div>
<div class="MsoNoSpacing">
So, we have established that the magnitude of the U.S.
trade deficit is highly correlated with the magnitude of the U.S. nonfinancial
sector net borrowing position. The magnitude of the U.S. nonfinancial sector
borrowing position is correlated with the magnitude of the U.S. federal
government budget deficit. Nonpartisan analysts are projecting higher federal
government budget deficits in the next two years. Thus, there is a high
probability that the magnitude of the U.S. nonfinancial sector net borrowing
position will increase in the next two years and with it, an increased
magnitude in the U.S. trade deficit.<o:p></o:p></div>
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<br /></div>
<div class="MsoNoSpacing">
There is a possibility that the likely widening in the
federal budget deficit would not result in a widening U.S. trade deficit. That
possibility rests on whether the nonfinancial sector, <i style="mso-bidi-font-style: normal;">excluding </i>the federal government, increases its <i style="mso-bidi-font-style: normal;">net lending</i> to the federal government to
prevent the <i style="mso-bidi-font-style: normal;">total</i> nonfinancial
sector, <i style="mso-bidi-font-style: normal;">including</i> the federal
government, from slipping further into a <i style="mso-bidi-font-style: normal;">net
borrowing</i> position. This is unlikely to happen if the federal budget
deficit reaches $1 <i style="mso-bidi-font-style: normal;">trillion+ </i>in FY
2019. That would be a $335+ increase in budget deficit vs. FY 2017. In the
three quarters ended Q3:2017, net lending by the nonfinancial sector <i style="mso-bidi-font-style: normal;">excluding</i> the federal government
amounted to $415 billion. So, net lending by the nonfinancial sector <i style="mso-bidi-font-style: normal;">excluding </i>the federal government would
have to increase by about 80% to prevent <i style="mso-bidi-font-style: normal;">total</i>
nonfinancial sector <i style="mso-bidi-font-style: normal;">net borrowing</i>
from widening and, thus, the U.S. trade deficit from widening. Possible, but
not probable.<o:p></o:p></div>
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<br /></div>
<div class="MsoNoSpacing">
At the outset of this commentary, I noted that President
Trump interprets the persistence of U.S. trade deficits as evidence of “unfair”
trade practices on the part of some of our trading partners. If the federal
government budget deficit widens as credible analysts project, there is a high
probability that the U.S. trade deficit also will widen. This could prompt the
Trump administration to adopt even more protectionist trade measures given its
view of the cause of trade deficits.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian, LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="https://www.blogger.com/the-econtrarian.blogspot.com">The Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Co., Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="file:///tel/1-920-818-0236">1-920-818-0236</a><u><o:p></o:p></u></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte<o:p></o:p></b></div>
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<br /></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">∆ + 6 = A Good
Life<o:p></o:p></b></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-10835295332466831312018-01-21T17:04:00.001-08:002018-01-21T17:07:47.907-08:00No Sugar High from Tax Cut Unless the Fed and Banking System Provide the Sugar<div align="right" class="MsoNoSpacing" style="text-align: right;">
January 22, 2018<o:p></o:p></div>
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<br /></div>
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<b style="mso-bidi-font-weight: normal;"><u>No Sugar High from Tax Cut Unless the
Fed and Banking System Provide the Sugar<o:p></o:p></u></b></div>
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<br /></div>
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There has been chatter about whether the Tax Cuts and
Jobs Act of 2017 (TCJA) will result in a temporary stimulus, or sugar high, to
U.S. economic activity because of the increase in corporate after-tax profits
and the increase in household disposable income that will flow from the
tax-rate cuts. How can putting this extra after-tax income in the hands of
businesses and households <i style="mso-bidi-font-style: normal;">not</i>
stimulate private sector spending? In order to answer this question, you have
to follow the money. And when I follow the money <i style="mso-bidi-font-style: normal;">completely</i>, I come to the conclusion that the tax cuts will <i style="mso-bidi-font-style: normal;">not</i> stimulate private sector spending <i style="mso-bidi-font-style: normal;">unless</i> the Fed and the banking system
finance the tax cut. In other words, TCJA will <i style="mso-bidi-font-style: normal;">not</i> produce an economic sugar high unless the Fed provides the
sugar.<o:p></o:p></div>
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If the federal government cuts our taxes, all else the
same, its budget deficit will increase. The tax cut in the short run, at least,
will result in lower federal government tax revenues. That’s what increasing
corporate after-tax profits and household disposable income is all about. But
unless the federal government simultaneously cuts its expenditures to match the
drop in its revenues, its budget deficit will increase. A wider budget deficit
means an increase in federal government borrowing. Now we are getting to the
nub of the issue – the implications of the <i style="mso-bidi-font-style: normal;">funding</i>
of the tax cut. I argue that unless the Fed and the banking system <i style="mso-bidi-font-style: normal;">create </i>the – here it comes – <i style="mso-bidi-font-style: normal;">thin-air</i> credit to finance the tax cut,
there will be no temporary stimulus from said tax cut.<o:p></o:p></div>
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Let’s assume that there is no <i style="mso-bidi-font-style: normal;">additional </i>thin-air credit (sum of bank credit, Fed reserves and
currency) created in reaction to the tax cut. In this case, the extra funds
needed to fund the wider deficit will have to be raised from the nonbank
nonfederal government sectors – households, businesses, nonfederal government
entities and the rest of the world. Because the U.S. Treasury cannot require
these sectors to fund the federal government’s widened deficit, market forces
must induce these sectors to voluntarily offer up these funds. The yield on
Treasury securities would be expected to rise sufficiently to induce these
sectors in the aggregate to reduce their current spending on goods and services
by the amount of the increased federal budget deficit and transfer this purchasing
power to the Treasury through the purchase of its additional securities
offerings.<o:p></o:p></div>
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Let’s net all of this out. Some households and businesses
that experience an increase in disposable income from TCJA might increase their
current spending on goods and services. But because the wider federal budget
deficit must be financed and we have stipulated no increase in thin-air credit,
some entities in the household, business, nonfederal government and foreign
sectors must cut their current spending on goods and services by the amount
that other entities increased their current spending on goods and services.
TCJA results in the federal government <i style="mso-bidi-font-style: normal;">dis</i>saving
more and the other sectors saving more. The net result of this is that TCJA
would <i style="mso-bidi-font-style: normal;">not </i>result in a net increase in
current spending on goods and services. Rather, the increased current spending
by some is offset the increased saving by others. TCJA, under these conditions,
would <i style="mso-bidi-font-style: normal;">not</i> produce an economic sugar
high.<o:p></o:p></div>
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Let’s look at some data. The blue bars in the chart below
are the annual observations of the net lending (+) or net borrowing (-) of the
U.S. federal government borrowing from 1965 through 2016. It should come as no
surprise that the blue bars are in negative territory during most of the
period. With the exceptions of 1999 and 2000, the federal government has run
budget deficits. The red bars in the chart represent the aggregated net lending
(+) or net borrowing (-) of households, nonfinancial businesses, state and
local governments and the rest of the world. With two exceptions, 1979 and
2006, these combined sectors have been net lenders. Notice that the blue bars
and red bars behave in a manner as though they are mirror images of each other.
That is, as the federal government’s net <i style="mso-bidi-font-style: normal;">borrowing</i>
increases in magnitude, i.e., the blue bars sink farther into <i style="mso-bidi-font-style: normal;">negative</i> territory, the combined
nonfinancial sectors’ (excluding the federal government) net <i style="mso-bidi-font-style: normal;">lending</i> increases in magnitude, i.e., the
red bars rise higher into <i style="mso-bidi-font-style: normal;">positive</i>
territory. The two series are <i style="mso-bidi-font-style: normal;">negatively</i>
correlated with absolute-value coefficient of 0.85. Recall that an
absolute-value coefficient of 1.00 represents <i style="mso-bidi-font-style: normal;">perfect</i> correlation. The data in the chart support my argument that
as the federal government <i style="mso-bidi-font-style: normal;">dis</i>saves
(borrows) more, other sectors save (lend) more. <o:p></o:p></div>
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<a href="https://3.bp.blogspot.com/-XPhuGzAcRmY/WmU3zE3zyuI/AAAAAAAABP8/VUXfqDq8Mi0xgvG2r1AJo7CbvptPKp8QACLcBGAs/s1600/Sugar%2BHigh.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="715" data-original-width="975" height="468" src="https://3.bp.blogspot.com/-XPhuGzAcRmY/WmU3zE3zyuI/AAAAAAAABP8/VUXfqDq8Mi0xgvG2r1AJo7CbvptPKp8QACLcBGAs/s640/Sugar%2BHigh.png" width="640" /></a></div>
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If the Fed and the banking system, combined, fund the
wider federal government budget resulting from TCJA, then the tax cuts <i style="mso-bidi-font-style: normal;">can</i> stimulate private sector spending on
goods and services. The Fed and the banking system have the ability to create
credit figuratively out of thin air. If households and businesses increase
their current spending on goods and services because of their increased
after-tax income <i style="mso-bidi-font-style: normal;">and</i> the Fed and the
banking system create the credit out of thin air to fund the wider federal
budget deficit, then no other entity needs to cut its current spending. Under
these circumstances, TCJA could produce an economic sugar high because the Fed
and the banking system are providing the sugar.<o:p></o:p></div>
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What would motivate the Fed and the banking system to
create the thin-air credit to fund the wider federal government budget deficit
resulting from TCJA? All else the same, the wider federal budget deficit would
represent a net increase in the aggregate <i style="mso-bidi-font-style: normal;">demand</i>
for credit. When the demand for something increases, upward pressure on the
price of that something is exerted. In this case, there would be upward
pressure on the level of the structure of interest rates. If the Fed does not
let the overnight federal funds rate drift upward with other interest rates,
then banks will have an incentive to lend more (create more thin-air credit)
because the spread between their loan rates and their marginal cost of funds
will have widened. But the banking system will need more Fed-created reserves
if bank loans and deposits in the aggregate increase. In order for the Fed to
keep the federal funds rate from rising, it will have to create more cash
reserves out of thin air. <o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<i style="mso-bidi-font-style: normal;">Will</i> the Fed
and the banking system fund the wider federal government budget deficit? In the
words of President Trump, “We’ll have to see about that.”<span style="mso-spacerun: yes;"> </span>The Fed currently is in a rate-raising mode.
Consumer inflation is picking up. Consumer spending growth has been strong. Labor
markets are tighter than a snare drum. And thin-air credit growth picked up in
Q4:2017, ironically, due to an acceleration in monetary base growth. I say
“ironically” because monetary base growth, all else the same, would have been
expected to slow as the Fed began to pare its securities holding in late 2017. Obviously,
all else was not the same. The upshot is that the Fed in 2018 will be moving
the level of the federal funds rate in the same direction that the TCJA-induced
wider federal government budget deficit will be moving it. By sheer chance,
then, the Fed is likely to limit the amount of thin-air credit funding of the
wider budget deficit.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust Co. of Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://the-econtrarian.blogspot.com/">The Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte <o:p></o:p></b></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNormal">
<b style="mso-bidi-font-weight: normal;">∆ + 6 = A Good Life</b><br />
<b style="mso-bidi-font-weight: normal;"><br /></b></div>
</div>
<div class="MsoNoSpacing">
Send any comments to me at econtrarian@gmail.com.</div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-16054925372314786042018-01-15T18:38:00.002-08:002018-01-21T17:07:02.095-08:00An Alternative Explanation for Walmart’s Announced Employee Bonuses and Wage-Rate Increase<div align="right" class="MsoNormal" style="text-align: right;">
January 16, 2018<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<b style="mso-bidi-font-weight: normal;"><u>An Alternative Explanation for Walmart’s
Announced Employee Bonuses and Wage-Rate Increase<o:p></o:p></u></b></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div class="MsoNoSpacing">
On January 11, <a href="https://news.walmart.com/2018/01/11/walmart-to-raise-us-wages-provide-one-time-bonus-and-expand-hourly-maternity-and-parental-leave">Walmart</a>
announced that it was raising its starting wage rate to $11 an hour, giving a
one-time bonus up to $1,000 to employees, expanding its parental/maternal leave
policy and providing employees adopting a child up to $5,000 per child in fees
associated with the adoption. In making these announcements, Doug McMillon,
Walmart president and CEO said: “<span lang="EN" style="mso-ansi-language: EN;">We
are early in the stages of assessing the opportunities tax reform creates for
us to invest in our customers and associates … Tax reform gives us the
opportunity to be more competitive globally and to accelerate plans for the
U.S.” Mr. McMillon is suggesting that Walmart’s employee compensation increases
were motivated by the Tax Cuts and Jobs Act of 2017 (TCJA). I have an
alternative explanation for Walmart’s recent beneficence – a growing shortage
of qualified employees.<o:p></o:p></span></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<span lang="EN" style="mso-ansi-language: EN;">Walmart, along
with all other corporations, has a fiduciary responsibility to maximize the
return on equity for its stockholders. All else the same, TCJA increases
Walmart’s after-tax profits. By increasing employee compensation by some
portion of its reduced tax liability emanating from TCJA, Walmart would be
reducing its after-tax profits (revenues minus expenses) from what they
otherwise would have been. This would be breaking with its fiduciary
responsibility to Walmart stockholders.<o:p></o:p></span></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<span lang="EN" style="mso-ansi-language: EN;">My alternative
explanation for Walmart’s January 11 announcement of employee compensation
increases is that it was <i style="mso-bidi-font-style: normal;">compelled</i> to
raise compensation in order to retain and attract new qualified employees. And
the reason Walmart needs to raise compensation to retain and attract new
qualified employees is because there is now a <i style="mso-bidi-font-style: normal;">shortage</i> of qualified employees in the retail sector at the <i style="mso-bidi-font-style: normal;">existing level of compensation</i>. This can
be seen in the chart below. Plotted in the chart are observations of the number
of job openings in a given month as a percent of the number of employees hired
in that month in the retail sector. The data are from the Job Openings and
Labor Turnover Survey (JOLTS) published by the Bureau of Labor Statistics. The
series begins in December 2000 and runs through November 2017. In November
2017, job openings in the retail sector were 105.0% of the number of hires.
That is, there were 5 percentage points more job openings in the retail sector
than there were new hires. This is the highest percentage of openings-to-hires
in the history of the series. <o:p></o:p></span></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://2.bp.blogspot.com/-UxAZ4ITVs3U/Wl1ljSUyewI/AAAAAAAABPU/doyo8rADG4oUsO-H9oBr69ZDoVJ87dwLQCLcBGAs/s1600/Walmart.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="475" data-original-width="975" height="310" src="https://2.bp.blogspot.com/-UxAZ4ITVs3U/Wl1ljSUyewI/AAAAAAAABPU/doyo8rADG4oUsO-H9oBr69ZDoVJ87dwLQCLcBGAs/s640/Walmart.png" width="640" /></a></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
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</v:shape><![endif]--><!--[if !vml]--><!--[endif]--></span><span lang="EN" style="mso-ansi-language: EN;"><o:p></o:p></span></div>
<div class="MsoNoSpacing">
<span lang="EN" style="mso-ansi-language: EN;">The demand for
retail employees exceeds the supply of employees at current compensation
levels. When the demand for something exceeds its supply, the price of that
something goes up. I believe that Walmart’s January 11 announcement of an
increase in employment compensation was motivated by a need to retain and
attract new qualified employees, <i style="mso-bidi-font-style: normal;">not</i>
by the recently-passed cut in corporate tax rates. <o:p></o:p></span></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Co. of Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://the-econtrarian.blogspot.com/">The
Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte <o:p></o:p></b></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNormal">
<b style="mso-bidi-font-weight: normal;">∆ + 6 = A Good Life<o:p></o:p></b></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Send any comments to me at econtrarian@gmail.com.</div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-88907765196755601312017-12-18T21:32:00.003-08:002017-12-18T21:47:34.193-08:00Festivus 2017 Airing of Grievances -- I Gotta a Lot of Problems with You, Taylor Rule<div align="right" class="MsoNoSpacing" style="text-align: right;">
December 19, 2017<o:p></o:p></div>
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<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<a href="https://en.wikipedia.org/wiki/Festivus"><b style="mso-bidi-font-weight: normal;">Festivus</b></a><b style="mso-bidi-font-weight: normal;"><u> 2017 Airing
of Grievances: I Gotta a Lot of Problems with You, Taylor Rule<o:p></o:p></u></b></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
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December 23<sup>rd</sup> is almost upon us. You know what
that means. It’s time for me to work up my annual airing of grievances for
Festivus 2017. Although I have myriad political-economic grievances for 2017, I
am going to concentrate on only one in this annual Festivus epistle – the
Taylor Rule. For decades, there has been a debate as to whether central bank
monetary policies should be guided by some clearly-defined rule or should
central banks be free to operate with discretion, i.e., by the seat of their
collective pants. I come down on the side of a rule vs. discretion. But <i style="mso-bidi-font-style: normal;">not</i> on the side of the rule most often
mentioned, the Taylor Rule.<o:p></o:p></div>
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In 1993, John Taylor, a Stanford University economics
professor, published a <a href="http://web.stanford.edu/~johntayl/Papers/Discretion.PDF">research paper</a>
in which he purported to <i style="mso-bidi-font-style: normal;">describe</i> how
the Federal Reserve had conducted monetary policy in terms of its movement of the
federal funds interest rate from 1987 through 1992. Essentially what Taylor did
was estimate a Fed <i style="mso-bidi-font-style: normal;">reaction</i> function
to consumer goods/service price inflation above or below a <i style="mso-bidi-font-style: normal;">perceived</i> Fed inflation target and to real GDP growth above or
below a <i style="mso-bidi-font-style: normal;">perceived </i>Fed real GDP
target. In his 1993 research paper, Taylor suggested that his <i style="mso-bidi-font-style: normal;">description</i> of past Fed monetary policy
decisions in terms of movement of the federal funds rate could be useful as a
guideline as to how the Fed <i style="mso-bidi-font-style: normal;">should</i>
operate in the future. Although Taylor did <i style="mso-bidi-font-style: normal;">not
</i>suggest in his 1993 research paper that the Fed should adhere rigidly to his
estimated reaction function, subsequently he has implicitly criticized Fed
policy for not hueing to his rule (see “<a href="https://economicsone.com/2015/04/16/a-monetary-policy-for-the-future/">A
Monetary Policy for the Future</a>”, April 16, 2015)<o:p></o:p></div>
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In its basic form, the Taylor reaction function is:<o:p></o:p></div>
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i = r*+ p + 0.5 (p-p*) + 0.5 (y as a % of y*)<o:p></o:p></div>
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where:<o:p></o:p></div>
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i = nominal fed funds rate<o:p></o:p></div>
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r = real equilibrium federal funds rate (usually 2%)<o:p></o:p></div>
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p = actual inflation rate (yr/yr % chg)<o:p></o:p></div>
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p*= target inflation rate (usually 2%)<o:p></o:p></div>
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y = actual real output<o:p></o:p></div>
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y* = potential real output<o:p></o:p></div>
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So, this formula states that for every 1% rise in
inflation above its target, the Fed would raise the federal funds rate by 0.5% and
similarly for every 1% increase in the output gap (actual real GDP as a percent
of potential real GDP, the Fed would raise the federal funds rate by 0.5%. If
actual inflation rate were equal to the Fed’s target inflation rate and if
actual real GDP were equal to potential real GDP (i.e., the output gap were
zero) then the <i style="mso-bidi-font-style: normal;">nominal</i>, or observed,
federal funds rate would equal the unobservable real equilibrium federal funds
rate, assumed by Taylor to be 2%, plus the inflation rate.<o:p></o:p></div>
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My grievances with the Taylor Rule arise out of the old
saw, it’s not what you don’t know that will hurt you, but what you <i style="mso-bidi-font-style: normal;">think</i> you know but <i style="mso-bidi-font-style: normal;">don’t</i>. There are two elements in the Taylor Rule that are assumed
to be known but are <i style="mso-bidi-font-style: normal;">not</i>, in fact
known. The first of these elements is “r”, the equilibrium real federal funds
rate. Just as the price of wheat <i style="mso-bidi-font-style: normal;">varies</i>
over time because of changes in the supply and demand for wheat, so does the
real equilibrium federal funds rate<i style="mso-bidi-font-style: normal;"> vary</i>
over time. Changes in fiscal policy, changes in business “animal spirits”,
changes in the age distribution of the population, to name just a few factors,
can change the equilibrium level of the real federal funds rate. If the<i style="mso-bidi-font-style: normal;"> actual</i> equilibrium real federal funds
rate has risen to 3% from the <i style="mso-bidi-font-style: normal;">assumed</i>
level of 2% in the Taylor Rule, then the Fed would persistently be keeping the
nominal federal funds rate too low for an extended period of time, which would
result in persistently accelerating inflation rate. This was why Milton
Friedman, may he rest in peace, argued against the Fed using an interest rate
as its policy instrument. No one knows what is the equilibrium level of the
nominal interest rate, much less the real interest rate, which would also require
knowledge of what inflation expectations are. <span style="mso-spacerun: yes;"> </span>In some instances, a 3% federal funds rate
might represent an accommodative monetary policy. In other instances it might
represent a restrictive monetary policy. If the Fed persistently keeps the
level of the federal funds rate low compared to its equilibrium level, an
inflationary spiral will result. If the Fed persistently keeps the federal funds
rate high compared to its equilibrium, a deflationary spiral will result.<o:p></o:p></div>
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The second unknown element in the Taylor Rule is the
level of <i style="mso-bidi-font-style: normal;">potential </i>real GDP.
Potential real GDP is a function of the size of the <i style="mso-bidi-font-style: normal;">potential</i> labor force, the productivity of that potential labor as
well as the productivity of other production factors and the rate of
technological advances. The easiest of these variables to estimate with a high
degree of accuracy is the potential labor force. Demography actually <i style="mso-bidi-font-style: normal;">is</i> a science.<o:p></o:p></div>
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Alright, even if we did know with a high degree of
certainty what was the equilibrium level of the real federal funds rate and the
level of potential real GDP, how do we know that 0.5 is the correct value of
the reaction coefficients to the inflation and output “gaps”? Why should the
coefficients be of the same value for each gap? Is the lag between a change in
the nominal federal funds rate and the inflation rate the same as it is for
real GDP?<o:p></o:p></div>
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Lastly, even if we did know with a high degree of
certainty what was the equilibrium level of the real federal funds rate, the
level of potential real GDP and the correct reaction coefficients of the
“gaps”, there are time lags with respect to the availability of inflation and
real GDP data. Currently, the Commerce Department releases the Personal
Consumption Expenditures (PCE) chain price index monthly with about a one-month
lag. For example, the November 2017 PCE price index will be released on
December 22, 2017. And of course, it is subject to revisions.<span style="mso-spacerun: yes;"> </span>Perhaps the Fed could use the consumer price
index that is updated daily from MIT’s <a href="http://www.thebillionpricesproject.com/">The Billion Prices Project</a>.
The Commerce Department’s first estimate of Q3:2017 GDP was released on October
27, 2017, the second estimate on November 29, and its third estimate on
December 21. Then in 2018, 2017 GDP data will be revised still more. Talk about
navigating in the fog without a GPS!<o:p></o:p></div>
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Now, let’s look at how the Taylor Rule would have guided
the level of the federal funds rate vs. the actual level of the funds rate and
comparing that with reported nominal GDP growth with implicit Taylor Rule
“targeted” nominal GDP growth. The blue line plotted in Chart 1 is the
four-quarter moving average of percentage-point differences between the
prescribed Taylor Rule level of the federal funds rate (calculated by Haver
Analytics using the PCE price index and the Congressional Budget Office
estimate of the real GDP output gap) and the actual level of the federal funds
rate. Implicit in the Taylor Rule is that nominal GDP growth is equal to the
growth in potential real GDP plus 2% inflation. The red bars in Chart 1 are
percentage point differences between year-over-year percent changes in reported
nominal GDP and the implicit Taylor Rule “targeted” nominal GDP. The GDP data
and the inflation data incorporate the latest revisions, which, of course would
not have been available to the Fed in real time. The data start in Q1:1987,
when Taylor started estimating his reaction function, and end in Q3:2017.<o:p></o:p></div>
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Chart 1<o:p></o:p></div>
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<a href="https://4.bp.blogspot.com/-aPM6QcAZsHE/WjikNyLZ25I/AAAAAAAABOI/ipiMDXap_rgr6blUM4WUmbD--J4sSU1LwCLcBGAs/s1600/Festivus%2B2017%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="732" data-original-width="975" height="480" src="https://4.bp.blogspot.com/-aPM6QcAZsHE/WjikNyLZ25I/AAAAAAAABOI/ipiMDXap_rgr6blUM4WUmbD--J4sSU1LwCLcBGAs/s640/Festivus%2B2017%2BChart%2B1.png" width="640" /></a></div>
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From Q1:1987 through Q3:1992, the Taylor Rule fed funds
rate was <i style="mso-bidi-font-style: normal;">below</i> the actual fed funds
rate (i.e., the blue line in Chart 1 is below zero). Yet, over most of this
period nominal GDP growth was above the implicit Taylor Rule targeted nominal
GDP growth (i.e., the red bars are predominantly above zero).<span style="mso-spacerun: yes;"> </span>This means that the Taylor Rule would have
performed <i style="mso-bidi-font-style: normal;">worse</i> than the actual
discretionary Fed policy in terms of achieving the Taylor Rule targeted nominal
GDP growth. The Taylor Rule’s finest hour, so to speak, was from Q4:2002
through Q4:2006 when the Taylor Rule fed funds rate was above the actual fed
funds rate and nominal GDP growth was above Taylor Rule targeted nominal GDP
growth. Yes, the Taylor Rule was superior to Greenspan’s discretion – a pretty
low bar in my opinion. All of the economic masochists out there would have
loved it if Taylor had “ruled” during the Great Recession. During most of the
last recession, the Taylor Rule fed funds rate was above the actual fed funds
rate. Had the Fed followed the Taylor Rule then, the Great Recession might have
turned into the second Great Depression. From Q3:2010 through Q3:2017, the
Taylor Rule fed funds rate has been above the actual fed funds rate. All else
the same, then, this current economic recovery/expansion would have been even
more anemic than it has been if the Taylor Rule had been followed. Call me
mean-spirited and self-centered, but I was disappointed when John Taylor was
not nominated for Fed chairman by President Trump. I wanted to see how much
damage the Taylor Rule would inflict on the U.S. economy.<o:p></o:p></div>
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At the outset of the commentary, I said that I was in
favor of the Fed monetary policy being guided by a rule rather than by
discretion – just not the Taylor Rule. The rule I would prefer is what I’ll
call the modified Milton Friedman monetary <i style="mso-bidi-font-style: normal;">quantity</i>
rule. Friedman advocated that the Fed target a steady rate of growth in some
definition of the money supply. Friedman was against discretion when it came to
conducting monetary policy because he recognized that there is a lot we really
don’t know but think we know when it comes to the macro behavior of the
economy. You can conceive of a Friedmanesque monetary quantity rule as kind of
Hippocratic Oath for central bankers – first, do no harm. Friedman did not
expect his rule to enable monetary policy to prevent the occurrence of business
cycles. Rather, he believed that his rule could reduce the amplitudes of
business cycles. As important, Friedman realized that if his monetary-quantity
growth target were too high or too low, it would not result in inflationary or
deflationary spirals. In other words, inflation might rise if the target were
set too high, but it would stabilize at some higher level. In contrast, if an
interest rate target were set too low, there was no mechanism to keep the rate
of inflation from continuing to rise except an increase in the interest rate
target to some unknown higher level.<o:p></o:p></div>
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Okay, let’s get to the modified Friedman monetary
quantity rule. I know that by now you have guessed it involves the Fed
targeting a steady rate of growth in thin-air credit, thin-air credit being the
sum of the credit created by depository institutions (commercial banks,
S&Ls and credit unions) plus Fed-created cash reserves of these depository
institutions and currency in circulation, or the monetary base. Plotted in
Chart 2 are the quarterly observations of the year-over-year percent changes in
nominal GDP along with the quarterly observations of the year-over-year percent
changes in the sum of depository institution credit plus the monetary base
(i.e., thin-air credit).<o:p></o:p></div>
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Chart 2<o:p></o:p></div>
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The two series appear to move in close tandem. When
thin-air credit growth rises, so does nominal GDP growth and <i style="mso-bidi-font-style: normal;">vice versa</i>. One glaring exception to
this “rule” occurs in 2008, when thin-air credit growth went up but nominal GDP
contracted. During this period of financial crisis, households, nonfinancial
institutions as well as financial institutions dramatically increased their
demands for liquidity. The Fed extended massive amounts of credit to financial
institutions to satisfy their increased demand for liquidity. Businesses tapped
their lines of credit at financial institutions to enhance their liquidity
positions, not to purchase new equipment or build inventories of goods. Cross -correlation
tests demonstrate that growth in thin-air credit tends to affect<i style="mso-bidi-font-style: normal;"> </i>growth in nominal GDP, not the other
way around. When the subperiod from Q1:2008 through Q4:2009 is omitted, the
contemporaneous correlation coefficient between the two series from Q1:1953
through Q3:2017 is 0.61. When thin-air credit growth is lagged by one quarter
to test whether thin-air credit growth <i style="mso-bidi-font-style: normal;">last
quarter</i> affects nominal GDP growth this <i style="mso-bidi-font-style: normal;">current
quarter</i>, the correlation coefficient <i style="mso-bidi-font-style: normal;">rises</i>
to 0.63. <o:p></o:p></div>
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However, when nominal GDP growth is lagged by one quarter
to test whether nominal GDP growth <i style="mso-bidi-font-style: normal;">last
quarter</i> affects thin-air credit growth this <i style="mso-bidi-font-style: normal;">current quarter</i>, the correlation coefficient <i style="mso-bidi-font-style: normal;">falls</i> to 0.56. Oh, and by the way, the Fed publishes <i style="mso-bidi-font-style: normal;">weekly </i>the level of “narrow” thin-air
credit – commercial bank credit, the bulk of depository institution credit, and
the monetary base. <o:p></o:p></div>
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What might a modified Friedman monetary quantity growth
rule look like? Both the median and average year-over-year percent change in
quarterly observations of real GDP was 3.1% from Q1:1953 through Q3:2017. Let’s
round it off to 3%. I don’t quite know why 2% is a magic number for an
annualized inflation target. Why not zero or even minus 2%? Whatever the
argument, let’s accept a 2% inflation target. That gives us a 5% annualized
nominal GDP growth target to shoot for. I ran an ordinary least-squares
regression with the year-over-year percent change in nominal GDP as the
dependent variable, year-over-year growth in thin-air credit lagged one quarter
as the explanatory variable along with a constant term. Based on the results of
this regression, in order to achieve 5% annualized growth in nominal GDP,
thin-air credit would have to grow at an annualized rate of 4.6%. (There is
evidence of a lot of serial correlation in nominal GDP growth. That is, this
quarter’s growth in nominal GDP is highly correlated with the previous quarter’s
growth. The estimate of target thin-air growth was made without correcting for
the serial correlation. When I did correct for it, the coefficient on thin-air
credit growth decreased, but remained statistically significant with a 99%
probability.) As an aside, in Q3:2017, thin-air credit was up 4.0% vs. Q3:2016.<o:p></o:p></div>
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So, the Fed has a read on the growth in narrow thin-air
credit on a weekly basis. If narrow thin-air credit is growing<i style="mso-bidi-font-style: normal;"> above</i> its target growth rate, the Fed
would <i style="mso-bidi-font-style: normal;">drain</i> a sufficient amount of
reserves from the financial system so as to get thin-air credit growth back to
target. If narrow thin-air credit were growing <i style="mso-bidi-font-style: normal;">below</i> target, the Fed would<i style="mso-bidi-font-style: normal;">
add</i> a sufficient amount of reserves to get thin-air credit growth back to
target. The guys and gals in the Chicago interest rate futures pits would love
this because short-maturity interest rates would be much more variable, similar
to the price of wheat.<o:p></o:p></div>
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Now that I have aired my 2017 grievances, it is time to
gather around the aluminum Festivus pole (aluminum is best, according to Frank
Costanza, because of its high strength-to-weight ratio) and join me in singing the
only Festivus carol I know:<o:p></o:p></div>
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<br /></div>
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<br /></div>
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<br /></div>
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<br /></div>
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<b style="mso-bidi-font-weight: normal;"><span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">A Festivus Carol <o:p></o:p></span></b></div>
<div align="center" class="MsoNormal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; mso-layout-grid-align: none; text-align: center; text-autospace: none;">
<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">(Lyrics by
Katy Kasriel to the melody of O’ Tannenbaum)<o:p></o:p></span></div>
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<br /></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">O’
Festivus, O’ Festivus,<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">This one’s
for all the rest of us.<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">The worst
of us, the best of us,<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">The shabby
and well-dressed of us.<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">We gather
‘round the ‘luminum pole,<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">Air
grievances that bare the soul.<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">No slights
too small to be expressed,<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">It’s good
to get things off our chests.<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">It’s time
now for the wrestling tests,<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">Feel free
to pin both kin and guests,<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">Festivus,
O’ Festivus,<o:p></o:p></span></div>
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<span style="font-family: "papyrus"; mso-bidi-font-family: Papyrus;">The holiday for the
rest of us.<o:p></o:p></span></div>
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Paul L. Kasriel<o:p></o:p></div>
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Founder, Econtrarian LLC<o:p></o:p></div>
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Senior Economic and Investment Advisor<o:p></o:p></div>
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<a href="http://www.lptrust.com/">Legacy Private Trust
Co. of Neenah, WI</a><o:p></o:p></div>
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<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://the-econtrarian.blogspot.com/">The
Econtrarian</a><o:p></o:p></div>
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1-920-818-0236<o:p></o:p></div>
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<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte <o:p></o:p></b></div>
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<b style="mso-bidi-font-weight: normal;">∆ + 6 = A Good Life<o:p></o:p></b></div>
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<o:p> Note: Because some entities have chosen to use the "comments" section of this blog as place to deposit their spam, I am disallowing comments going forward. If you have a legitimate comment, send it directly to me via my email address and I will try to post it on the blog.</o:p></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-4337062821405263282017-12-09T13:28:00.003-08:002017-12-09T22:21:08.808-08:00Don't Expect an Investment Boom if the Corporate Tax Rate Is Cut<div align="right" class="MsoNormal" style="text-align: right;">
December 11, 2017<o:p></o:p></div>
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<b style="mso-bidi-font-weight: normal;"><u>Don’t Expect an Investment Boom if the Corporate
Tax Rate Is Cut<o:p></o:p></u></b></div>
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<br /></div>
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It appears as though the rate on U.S. federal corporate
profits is going to be reduced. Although U.S. corporations may be considered
“people” in terms of the First Amendment, they are not “people” when it comes
to paying taxes. Corporations are <i style="mso-bidi-font-style: normal;">de
facto</i> tax <i style="mso-bidi-font-style: normal;">collectors</i>, <i style="mso-bidi-font-style: normal;">not</i> tax payers. Real people ultimately
pay the taxes in one way or another on the profits that corporations earn. So,
why don’t we relieve corporations of their tax-collecting duties and tax their
shareholders directly on the accrued profits of corporations in which they own
shares as Laurence Kotlikoff, Boston U. econ professor and 2016 write-in presidential candidate, has suggested? If this were done, the tax on dividends and, thus, the double
taxation of corporate profits would be eliminated. Alas, this kind of tax
reform is not in the cards, but a cut in the corporate profits tax would be a
step in the right direction.<o:p></o:p></div>
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One of the arguments being made in favor of the cut in
the corporate profits tax rate is that it would unleash a torrent of investment
on the part of corporations. In turn, this increase in business investment
would enhance the potential real growth in the economy and would increase the
capital-to-labor ratio. An increase in the capital-to-labor ratio would raise
the productivity of labor, which eventually would lead to an increase in real
wages.<o:p></o:p></div>
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Whoa, Nellie! There are some ugly facts that counter this
beautiful hypothesis. <span style="mso-spacerun: yes;"> </span>For starters,
profits from domestic corporate operations after federal tax as a percent of
GDP are relatively high in an historic context, as shown in Chart 1. From 1955
through 2016, the high in nominal after-tax corporate profits from domestic
operations as a percent of nominal GDP occurred in 2012 at 7.6%. In 2016,
after-tax profits relative to GDP stood at 6.9% vs. a median value of 5.5%.
Despite corporate after-tax profits being relatively high, real business fixed
investment (structures, equipment and intellectual property products) as a
percent of real after-tax corporate profits is <i style="mso-bidi-font-style: normal;">not</i> exceptionally high, as shown in Chart 2. In 2016, real business
fixed investment was 191.5% of real after-tax corporate profits. Although this
was above the median of 174.5%, it was well below the record high of 323.7% of
2000 or the near-record high of 300.7% in 2008. So, despite U.S. corporate
after-tax profits currently being high absolutely and relatively, real business
fixed investment currently is not particularly high compared to real after-tax
profits. Although a decrease in the corporate profits tax rate would, all else
the same, increase after-tax corporate profits, it is not clear from the data
presented in Charts 1 and 2 that an increase in after-tax corporate profits
would result in a big increase in business fixed-investment spending.<o:p></o:p></div>
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</div>
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<br /></div>
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<br /></div>
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<br /></div>
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Chart 1<o:p></o:p></div>
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Chart 2<o:p></o:p></div>
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It’s just a hunch on my part, but I suspect one of the
most important factors driving business capital spending is <i style="mso-bidi-font-style: normal;">actual evidence of demand</i> for the
products produced by businesses. The world <i style="mso-bidi-font-style: normal;">might</i>
beat a path to my doorstep if I build a better mousetrap, but I’m taking a big
risk if I scale up my better-mousetrap production capability by purchasing a
lot of new equipment and the world, in fact, does <i style="mso-bidi-font-style: normal;">not</i> beat a path to my doorstep. This hunch on my part might explain
why there is a high positive correlation, 0.70, between <i style="mso-bidi-font-style: normal;">prior</i> changes in real consumer spending and <i style="mso-bidi-font-style: normal;">current</i> changes in real business fixed-investment spending (see
Chart 3).<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 3<o:p></o:p></div>
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<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Before betting that a cut in the corporate profits tax
will result in an investment boom, it might be instructive to see what
nonfinancial corporations have been using their after-tax profits for in recent
<i style="mso-bidi-font-style: normal;">decades</i>. The data in Chart 4 show
that starting in the mid 1980s, nonfinancial corporations stepped up their
dividend payments and equity retirement (share buybacks) relative to their
after tax profits. How could the sum of dividend payments and equity retirement
be more than 100% of after-tax corporate profits in some cases? Corporate
borrowing.<o:p></o:p></div>
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<o:p> </o:p> </div>
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<br /></div>
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<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 4<o:p></o:p></div>
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<a href="https://1.bp.blogspot.com/-Wr7pWrQOsqM/WixVS-F6y0I/AAAAAAAABNU/S4u8VDxuVz4gtVw7vfzMMdajaOBS0SFyACLcBGAs/s1600/corp%2Btax%2Brate%2Bchart%2B4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="732" data-original-width="975" height="480" src="https://1.bp.blogspot.com/-Wr7pWrQOsqM/WixVS-F6y0I/AAAAAAAABNU/S4u8VDxuVz4gtVw7vfzMMdajaOBS0SFyACLcBGAs/s640/corp%2Btax%2Brate%2Bchart%2B4.png" width="640" /></a></div>
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<div class="MsoNoSpacing">
In sum, by all means, cut the tax rate on corporate
profits. But don’t expect the tax-rate cut to unleash a torrent of business
investment spending. Currently, corporate <i style="mso-bidi-font-style: normal;">after-tax</i>
profits already are high relative to GDP, yet business fixed-investment
spending relative to after-tax profits is <i style="mso-bidi-font-style: normal;">not</i>
exceptionally high. Moreover, in recent decades, corporations have shown a
preference for using after-tax profits to pay out dividends and buy back shares
rather than make capital investments.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Co. of Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://the-econtrarian.blogspot.com/">The
Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte <o:p></o:p></b></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">∆ + 6 = A Good
Life</b><o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com55tag:blogger.com,1999:blog-3399546775946309435.post-60395833313587812292017-11-28T18:15:00.001-08:002018-02-18T12:28:00.239-08:00The S&P 500 Is Not Expensive According to the Kasriel Valuation Model<div align="right" class="MsoNoSpacing" style="text-align: right;">
November 29, 2017<o:p></o:p></div>
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<b style="mso-bidi-font-weight: normal;"><u>The S&P 500 Is <i style="mso-bidi-font-style: normal;">Not </i>Expensive According to the Kasriel Valuation Model<o:p></o:p></u></b></div>
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In each of the first three quarters of 2017, there have
been double-digit year-over-year percentage increases in the quarterly average
level of the S&P 500 stock-price index – 19.3% in Q1, 15.5% in Q2 and 14.2%
in Q3. Although there were year-over-year contractions in the S&P 500 index
of 5.6% in Q1:2016 and 1.3% in Q2:2016, there has not been a year-over-year
contraction of 10% or more since Q3:2009. With the S&P 500 stock-price
index hitting record highs in recent weeks and no contraction of 10% or more in
it in eight years, one could reasonably wonder if large cap stocks have gotten
expensive. In terms of the Kasriel stock market valuation model, the S&P
500 stock price index was <i style="mso-bidi-font-style: normal;">not</i>
expensive in an historical context as of this past third quarter.<o:p></o:p></div>
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The essence of the Kasriel stock market valuation model
is a calculated <i style="mso-bidi-font-style: normal;">theoretical</i> market
capitalization of a group of stocks compared with the <i style="mso-bidi-font-style: normal;">actual</i> market capitalization. If the actual market cap is larger
than the theoretical market cap, then the stock market group is overvalued. If
the actual market cap is less than the theoretical market cap, then the stock
market group is undervalued.<o:p></o:p></div>
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The theoretical market cap is calculated by discounting
corporate earnings by a corporate bond yield. Thus, the theoretical market cap
varies positively with the level of earnings and negatively with the level of
bond yields. For corporate earnings, I have used quarterly observations of
aggregate S&P 500 <i style="mso-bidi-font-style: normal;">reported</i>
earnings, starting in 1964:Q1. (I would have preferred to use <i style="mso-bidi-font-style: normal;">operating </i>earnings, earnings adjusted
for one-time special events. But in my database, operating earnings data do not
begin until 1988:Q1.) I smooth the earnings series with some highfalutin
econometric technique called the Hodrick-Prescott filter. The Hodrick-Prescott
filter is supposed to remove the cyclical component of a series. Think of it as
less arbitrary technique than a moving average, such as Shiller’s use of a
10-year moving average. Why 10 years? Why not 9 or 11 years? So, my theoretical
S&P 500 market cap is Hodrick-Prescott filtered quarterly aggregate S&P
earnings discounted by the quarterly average level of the corporate BAA bond
yield. After calculating the theoretical market cap of the S&P 500 stocks,
I calculate the percentage that the actual S&P market cap is over or under
the theoretical S&P 500 market cap. <o:p></o:p></div>
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The results of these calculations are plotted in Chart 1.
According to the Kasriel model, S&P 500 stocks in the aggregate were
overvalued by 4.4% in 2017:Q3. Compared to the average overvaluation of 36.1%
over the entire sample period, a 4.4% overvaluation is small potatoes. The
level of the corporate bond yield used to discount smoothed annualized earnings
of $899.1 billion in this past third quarter was 4.35%. Given the same level of
annualized earnings, a 100 basis point increase in the corporate bond yield
would put third-quarter S&P 500 stocks 28.4% overvalued, still short of the
sample average of 36.1% overvaluation. <o:p></o:p></div>
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Chart 1<o:p></o:p></div>
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<a href="https://3.bp.blogspot.com/-bUPPHGqn4Vc/Wh4XwgbzMmI/AAAAAAAABMY/ZNoEE0xiFyUQYROkhroGdt7TxaDfVcAEACEwYBhgL/s1600/S_P%2BNot%2BOvervalued%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="565" data-original-width="849" height="424" src="https://3.bp.blogspot.com/-bUPPHGqn4Vc/Wh4XwgbzMmI/AAAAAAAABMY/ZNoEE0xiFyUQYROkhroGdt7TxaDfVcAEACEwYBhgL/s640/S_P%2BNot%2BOvervalued%2BChart%2B1.png" width="640" /></a></div>
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Testing the lead/lag relationship between the Kasriel
valuation model and the year-over-year percent change in the S&P 500 stock
price index shows that the highest negative correlation (-.20) between the two
series is obtained when the over/under valuation measure is <i style="mso-bidi-font-style: normal;">lagged</i> by five quarters. So, the <i style="mso-bidi-font-style: normal;">current</i> quarter’s over/under valuation
estimate has its greatest effect on the year-over-change in the S&P 500
stock price index five quarters in the <i style="mso-bidi-font-style: normal;">future</i>.
Let’s plot the year-over-year percent change in the quarterly average of the
S&P 500 stock price index against the Kasriel model of over/under valuation
estimates <i style="mso-bidi-font-style: normal;">lagged five quarters </i>to see
how the Kasriel model comports with the behavior of stock prices. These data
are plotted in Chart 2.<o:p></o:p></div>
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Given the low absolute value of the correlation
coefficient between the two series, 0.20, you would be correct in assuming that
the Kasriel over/under valuation model does not do a stellar job in predicting
the year-over-year percent changes in the S&P 500 stock price index. (Gosh,
and I thought it would be easy to accurately predict stock prices!) But the
Kasriel model does catch some big moves. In terms of stock price rallies, the
Kasriel model does show stocks were <i style="mso-bidi-font-style: normal;">under</i>valued
<i style="mso-bidi-font-style: normal;">preceding</i> the stock price <i style="mso-bidi-font-style: normal;">rallies</i> of the mid 1960s, mid 1970s,
early 1980s and early 2010s. And the Kasriel model also shows that stocks were
extremely <i style="mso-bidi-font-style: normal;">over</i>valued<i style="mso-bidi-font-style: normal;"> preceding</i> the stock price <i style="mso-bidi-font-style: normal;">declines</i> of the late 1980s, early 2000s
and late 2000s. However, significant stock price rallies in the early 1970s, in
the early to mid 1980s, in the early 1990s and in the late 1990s were <i style="mso-bidi-font-style: normal;">preceded</i> by Kasriel model <i style="mso-bidi-font-style: normal;">overvaluations</i> near or above the average
overvaluation reading of 36.1%, which again shows that the stock market can
stay overvalued longer than you can meet the margin calls on your short
positions!<span style="mso-spacerun: yes;"> </span><o:p></o:p></div>
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Chart 2<o:p></o:p></div>
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2017:Q3 marks the 34<sup>th</sup> quarter in which the
S&P 500 stock price index has gone without a quarter-to-quarter decline of
10% or more. In the past 34 quarters, the S&P 500 stock price index has
increased at a compound annual rate of 14.0%. The average 34-quarter compound
annual rate of change in the S&P price index has been 6.6% in the period
from Q1:1964 through Q3:2017. Despite this bull-market run, S&P 500 stocks
in the aggregate do not appear to be overvalued in an historical context. Hodrick-Prescott
filtered S&P 500 aggregate earnings grew at a compound annual rate of 6.55%
in the 34 quarters ended 2017:Q3, which is less than the average 34-quarter
compound annual growth in these earning of 7.75% in the period from 1972:Q3
through 2017:Q3. So, the key driver of the theoretical S&P 500 market cap
and thus undervaluation or relatively low overvaluation of the S&P 500 in
the past 34 quarters has been the low level of the discount factor, the yield
on corporate BAA bonds.<o:p></o:p></div>
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Given the low correlation coefficient of -0.20 between
percentage changes in the S&P 500 stock price index and the Kasriel model
over/under valuation estimates, there obviously are other factors that have significant
effects on the behavior of S&P 500 stock prices such as <i style="mso-bidi-font-style: normal;">expected</i> government tax and regulatory
policies, as well as geopolitical events. Thus, if the S&P 500 stock price
index were to plunge 10% or more in the next four quarters or so, it would
likely be the result of some factor <i style="mso-bidi-font-style: normal;">other
than</i> stocks currently being overvalued. (Of course, by writing this, I
probably have put the “kiss of death” on the U.S. stock market!) <o:p></o:p></div>
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<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
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Founder, Econtrarian LLC<o:p></o:p></div>
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Senior Economic and Investment Advisor<o:p></o:p></div>
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<a href="http://www.lptrust.com/">Legacy Private Trust
Co. of Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://the-econtrarian.blogspot.com/">The
Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte <o:p></o:p></b></div>
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<b style="mso-bidi-font-weight: normal;">∆ + 10 = A Good
Life</b><o:p></o:p></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com4tag:blogger.com,1999:blog-3399546775946309435.post-62091607915331174012017-11-22T08:18:00.001-08:002018-10-05T13:41:34.609-07:00At Least We Can Be Thankful for the 11 "Fair" Traders<div align="right" class="MsoNoSpacing" style="text-align: right;">
November 22, 2017<o:p></o:p></div>
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<b style="mso-bidi-font-weight: normal;"><u>At Least We Can Be Thankful for the 11
“Fair” Traders<o:p></o:p></u></b></div>
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Most of the rest of the world is so unfair to us (U.S.)
when it comes to trade. If it were not for this unfairness, perhaps the U.S
would rank higher than ninth in the world in per capita GDP adjusted for
purchasing power parity (PPP), according to the <a href="https://data.worldbank.org/indicator/NY.GDP.PCAP.PP.CD?view=chart,">World
Bank</a>. <o:p></o:p></div>
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To see who the “good” and “bad” guys are in terms of U.S.
trading partners, I looked through the list of the 41 countries enumerated in
my Haver Analytics database that are U.S. trading partners. (This is not a
complete list of individual country trading partners, just the list provided in
the database I have. For a more complete list, I would have to pay up for the
“premium” database.) With these 41 countries, the U.S. ran a trade deficit in <i style="mso-bidi-font-style: normal;">goods</i> of $746 billion in 12 months ended
September 2017. The U.S. ran a goods trade surplus with only 11 of the 41
countries. That aggregate goods trade surplus was $113 billion. That means that
the aggregate U.S. goods<i style="mso-bidi-font-style: normal;"> </i>trade
deficit with the other 30 countries was $859 billion. So unfair!<o:p></o:p></div>
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The 11 countries we ran a surplus with were Hong Kong
(less a country than a wholly-owned subsidiary, $31.9 billion), Netherlands
($24.3 billion), Belgium ($14.9 billion), Australia ($13.7 billion), Singapore
($11.0 billion), Brazil ($6.4 billion), Argentina ($4.2 billion), Chile ($2.5
billion), Egypt ($2.3 billion), UK ($1.6 billion) and Norway (less than $0.1
billion). Goods deficits with four countries accounted for almost 66% of the
$859 billion aggregate deficit with the 30 countries with which we ran trade
deficits in goods – China ($363.2 billion), Mexico ($69.6 billion), Japan
($69.5 billion) and Germany ($63.0 billion). As an aside, while the put-upon
U.S. ranks ninth in terms of PPP per capita GDP, as mentioned above, those
trade cheaters Germany, Japan, Mexico and China rank 16<sup>th</sup>, 22<sup>nd</sup>,
61<sup>st</sup> and 70<sup>th</sup>, respectively. I guess cheaters never
really win in the end.<o:p></o:p></div>
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Given our aggregate $746 billion goods trade deficit with
these 41 countries, I found it curious that only 11 countries were “fair”
traders with us – “fair” as it has come to mean in some circles as countries running
a goods trade deficit with <i style="mso-bidi-font-style: normal;">us</i>. Could 73%
of our trading partners really be cheaters? Then I remembered an “alternative”
fact. Namely, if aggregate spending on goods and services in an economy (or
household) is greater than the value of goods and services produced in that
economy (or household), then, by definition, that economy (or household) must
be incurring a trade deficit, in effect, must be borrowing goods and services
from the rest of the world. <o:p></o:p></div>
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Are these 30 countries with which we are running goods
trade deficits <i style="mso-bidi-font-style: normal;">making</i> us run trade deficits
with them via unfair trade policies? Not bloody likely! The U.S. persistently
runs aggregate trade deficits because its economic sectors – households,
businesses and governments – collectively spend more on goods and services than
they produce. One possible reason for this is illustrated in the chart below.
The green bars in the chart represent the nominal value of goods and services
produced in the U.S. economy, nominal GDP, minus the sum of nominal consumer
and business spending. The green bars are uniformly in positive territory,
indicating that U.S. private sector nominal spending on goods and services has
been consistently <i style="mso-bidi-font-style: normal;">less than</i> the
nominal value of goods and services produced in the U.S. So, why have we run
trade deficits during this period? Because of the blue line in the chart – the
nominal value of government spending on goods and services. Government sector
spending has consistently been higher than the surplus of GDP vs. private
sector spending. All else the same, if government sector spending on goods and
services were nil, then the U.S. would have been running trade surpluses during
this period rather than trade deficits. Alternatively, given the amount of
government sector spending,<span style="mso-spacerun: yes;"> </span>if the structure
of U.S. interest rates had been higher <span style="mso-spacerun: yes;"> </span>and/or the U.S. tax structure had been
different so as to encourage more private sector saving (i.e., discourage
private sector spending on goods and services), the U.S. might have run trade
surpluses rather than deficits.<o:p></o:p></div>
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<a href="https://4.bp.blogspot.com/-Pa1gZHkin5E/WhWjSF6iM5I/AAAAAAAABL4/ckRW3pH9xfIV3GbTRJgcvgXlgxeiEu5_ACLcBGAs/s1600/Fair%2B11.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="497" data-original-width="975" height="326" src="https://4.bp.blogspot.com/-Pa1gZHkin5E/WhWjSF6iM5I/AAAAAAAABL4/ckRW3pH9xfIV3GbTRJgcvgXlgxeiEu5_ACLcBGAs/s640/Fair%2B11.png" width="640" /></a></div>
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Trade deficits are not inherently an economic “bad”. It
depends on how an economy incurring trade deficits allocates its spending. If
trade deficit is run so as to increase spending on physical capital goods and
human capital while still allowing for a satisfying amount of consumer
spending, then a trade deficit can be beneficial. With the investment in
physical and human capital, the economy can grow faster in the future,
providing enough extra income to service external debt while not having to
curtail future domestic spending. But if the borrowed resources emanating from
trade deficits are used to increase household and government consumption at the
expense of physical/human capital spending, then the economy’s potential growth
will not be enhanced. Therefore, external debt servicing will require a
curtailment in domestic spending.<o:p></o:p></div>
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Regardless, as we gorge on Thursday and splurge on
Friday, let’s give thanks to the aforementioned “fair”-trading 11.<o:p></o:p></div>
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Paul L. Kasriel<o:p></o:p></div>
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Founder, Econtrarian LLC<o:p></o:p></div>
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<a href="http://www.lptrust.com/">Legacy Private Trust
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<a href="http://the-econtrarian.blogspot.com/">The
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1-920-818-0236<o:p></o:p></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com0tag:blogger.com,1999:blog-3399546775946309435.post-16611046339609150972017-10-22T14:22:00.000-07:002017-10-22T14:22:09.830-07:00Where Has All the Inflation Gone? When Will the Fed Ever Learn?<div align="right" class="MsoNoSpacing" style="text-align: right;">
October 23, 2017<o:p></o:p></div>
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<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<b style="mso-bidi-font-weight: normal;"><u>Where Has All the Inflation Gone? When
Will the Fed Ever Learn?<o:p></o:p></u></b></div>
<div align="right" class="MsoNoSpacing" style="text-align: right;">
With apologies to <a href="https://en.wikipedia.org/wiki/Where_Have_All_the_Flowers_Gone%3F">Pete
Seeger</a><o:p></o:p></div>
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<br /></div>
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The Fed is dazed and confused (with apologies to <a href="https://en.wikipedia.org/wiki/Dazed_and_Confused_(song)#Led_Zeppelin_studio_recording">Jake
Holmes</a>) about the lack of goods/services price inflation currently present
in the U.S. economy. No matter how you slice or dice the Personal Consumption
Expenditures (PCE) Chain Price Index, its annualized growth has not trended above
2% since 2011. How can this be given that the unemployment rate of those
covered by unemployment insurance is at an historic low of 1.3% (see Chart 2)?
Wherefore art thou, <a href="https://en.wikipedia.org/wiki/William_Phillips_(economist)">A.W. Phillips</a>
and your curve purporting to show an inverse relationship between the level of
the unemployment rate and the rate of goods/services price inflation?<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 1<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://2.bp.blogspot.com/-Z8waLbcW190/We0K7JY0xNI/AAAAAAAABKY/K0VlUNCItdIIx2zEJXi505nG5fP6NAUqACLcBGAs/s1600/Where%2BHas%2BAll%2Bthe%2BInflation%2BGone%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="455" data-original-width="975" height="298" src="https://2.bp.blogspot.com/-Z8waLbcW190/We0K7JY0xNI/AAAAAAAABKY/K0VlUNCItdIIx2zEJXi505nG5fP6NAUqACLcBGAs/s640/Where%2BHas%2BAll%2Bthe%2BInflation%2BGone%2BChart%2B1.png" width="640" /></a></div>
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Chart 2<o:p></o:p></div>
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Why the Fed is bothered by the lack of consumer price
inflation is a mystery to me. With whatever unemployment rate you choose
plumbing cycle, if not decade lows, why is the Fed concerned by persistent low
consumer price inflation? Is this not an outcome to celebrate rather than
despair?<o:p></o:p></div>
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<span style="mso-spacerun: yes;"> </span>Whatever the reason
for the Fed’s angst, with regard to the alleged <i style="mso-bidi-font-style: normal;">inverse</i> relationship (<i style="mso-bidi-font-style: normal;">negative
</i>correlation) between the unemployment rate and consumer price inflation,
try as I might, I could not find a consistent one. Starting with quarterly
observations from 1955, the best I could tease out of the data was a <i style="mso-bidi-font-style: normal;">positive </i>correlation of 0.05 (out of a
maximum absolute value of 1.00) when the four-quarter moving average of the
unemployment rate was advanced by four quarters (see Chart 3). <b style="mso-bidi-font-weight: normal;">In effect, the data show no consistent
relationship between the level of the unemployment rate and the rate of
consumer inflation over time – inverse or positive.</b><o:p></o:p></div>
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Chart 3<o:p></o:p></div>
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<div class="MsoNormal">
Not one to give up on A. W., I tried a variation on his
theme. The logic underlying the Phillips Curve is that the lower the
unemployment rate, the narrower is the <i style="mso-bidi-font-style: normal;">gap
</i>between actual real GDP and the economy’s <i style="mso-bidi-font-style: normal;">potential</i> real GDP. Potential GDP is a function of guesstimates of
the size of the <i style="mso-bidi-font-style: normal;">potential</i> labor force
and <i style="mso-bidi-font-style: normal;">potential </i>total factor
productivity. The hypothesis is that as <i style="mso-bidi-font-style: normal;">actual
</i>real GDP rises relative to <i style="mso-bidi-font-style: normal;">potential</i>
real GDP, consumer price inflation also should rise. That is, there should be a
<i style="mso-bidi-font-style: normal;">positive</i> correlation between the
relative gap between actual and potential real GDP and consumer price
inflation. And sure enough, I was able to find one using the Congressional
Budget Office’s estimates of potential real GDP. When advanced by five
quarters, the real GDP relative gap has a <i style="mso-bidi-font-style: normal;">positive
</i>correlation with the rate of consumer price inflation of 0.22 (see Chart
4). An absolute correlation coefficient of 0.22 is nothing to write home about
(remember, the maximum possible is 1.00), but at least this version of the
Phillips relationship has the correct sign.<o:p></o:p></div>
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Chart 4<o:p></o:p></div>
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It would appear that the Fed is using an incorrect
“model” to forecast consumer price inflation. There was another economist who
had an hypothesis about the cause of consumer price inflation. His hypothesis
was that consumer price inflation is “always and everywhere a monetary phenomenon”.
Of course, that economist was the late (may he rest in peace) Milton Friedman. <o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
So, let’s look at the relationship between a monetary
variable and consumer price inflation. I assume that you are not shocked that
the monetary variable I have chosen to test the Friedman hypothesis is what I
refer to as thin-air credit. I am going to use my “broad” definition of
thin-air credit – the sum of the monetary base (reserves of the depository
institution system and currency in circulation) plus the credit created by the
depository institution system. Commercial banks, S&Ls and credit unions
constitute the depository institution system. The Friedman hypothesis is that
there should be a <i style="mso-bidi-font-style: normal;">positive</i>
correlation between growth in the chosen monetary variable and the consumer
price inflation rate.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
So, let’s look at the data. Plotted in Chart 5 are the
year-over-year percent changes in quarterly observations of “broad” thin-air
credit and year-over-year percent changes in quarterly observations of PCE
Chain Price Index. The period of observation begins in Q1:1956. The highest
correlation over this sample occurs when growth in “broad” thin-air credit is
advanced by 10 quarters. That <i style="mso-bidi-font-style: normal;">positive</i>
correlation has a value of 0.59 – almost three times as large as the highest
positive correlation between the real GDP relative gap and consumer inflation. The
Fed ought to expand its list of suspects to include the behavior of thin-air
credit in order to solve the mystery of recent low consumer price inflation.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<br /></div>
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Chart 5<o:p></o:p></div>
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<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
To smooth things out a bit, I have plotted in Chart 6
year-over-year percent changes in <i style="mso-bidi-font-style: normal;">annual
averages</i> of “broad” thin-air credit and the PCE Chain Price Index from 1953
through 2016. When using annual averages, the highest positive correlation
between the two variables (0.60) occurs when growth in “broad” thin-air credit
is advanced by three years. Suffice it to say, that there is a long lag between
growth in thin-air credit and consumer price inflation. If that sounds
familiar, it was what Milton Friedman observed between money supply growth and
price inflation when he looked at the data years ago. The two series in Chart 6
are plotted <i style="mso-bidi-font-style: normal;">contemporaneously </i>(i.e.,
neither series is advanced or retarded) because all I want to do is look for
trend breaks in the data. I can identify three distinct periods of growth in
“broad” thin-air credit – 1953 through 1988, 1994 through 2008 and 2011 through
2016. From 1953 through 1988, the median year-over-year percent change in
“broad” thin-air credit was 8.7%. During the same period, the median
year-over-year percent change in the PCE Chain Price Index was 3.5%. From 1994
through 2008, the median year-over-year percent change in “broad” thin-air
credit slowed to 6.9%. During the same period, the median year-over-year
percent change in the PCE Chain Price Index slowed to 2.1%. From 2011 through
2016, the median year-over-year percent change in “broad” thin-air credit
slowed to 4.5%. During the same period, the median year-over-year percent
change in the PCE Chain Price Index slowed to 1.4%. I see a pattern here. <b style="mso-bidi-font-weight: normal;">There has been a secular slowing in “broad”
thin-air credit growth accompanied by a secular slowing in consumer inflation.<o:p></o:p></b></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
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<br /></div>
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<br /></div>
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<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 6<o:p></o:p></div>
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<a href="https://3.bp.blogspot.com/-xbOhKJncySI/We0L4dZosWI/AAAAAAAABKs/vVS05ZaheJ4D7FRC79er8eAQxzdLpuwKgCLcBGAs/s1600/Where%2BHas%2BAll%2Bthe%2BInflation%2BGone%2BChart%2B6.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="732" data-original-width="975" height="480" src="https://3.bp.blogspot.com/-xbOhKJncySI/We0L4dZosWI/AAAAAAAABKs/vVS05ZaheJ4D7FRC79er8eAQxzdLpuwKgCLcBGAs/s640/Where%2BHas%2BAll%2Bthe%2BInflation%2BGone%2BChart%2B6.png" width="640" /></a></div>
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<span style="mso-no-proof: yes;"><!--[if gte vml 1]><v:shape
id="Picture_x0020_8" o:spid="_x0000_i1025" type="#_x0000_t75" style='width:468pt;
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<div class="MsoNoSpacing">
My data tests (not all included here) have convinced me
that percent changes in “broad” thin-air credit <i style="mso-bidi-font-style: normal;">lead</i> percent changes in the PCE Chain Price Index. There has been a
marked slowing in the growth of “broad” thin-air credit since the Great
Recession. There also has been a slowing in the rate of consumer inflation.
Where has all the inflation gone? The way of “broad” thin-air credit. When will
the Fed ever learn?<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Co. of Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://the-econtrarian.blogspot.com/">The
Econtrarian</a><o:p></o:p></div>
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1-920-818-0236<o:p></o:p></div>
Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com54tag:blogger.com,1999:blog-3399546775946309435.post-9733493166549497772017-09-15T11:51:00.001-07:002017-09-15T11:51:39.878-07:00Some "Alternative" Facts in Response to the Economic Nonsense Being Propagated by Some Politicos<div class="separator" style="clear: both; text-align: center;">
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<br />Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com157tag:blogger.com,1999:blog-3399546775946309435.post-128132187781574682017-09-11T18:23:00.003-07:002017-09-11T18:23:28.105-07:00There Are No Silver Linings with Natural Disasters<div align="right" class="MsoNoSpacing" style="text-align: right;">
September 11, 2017<o:p></o:p></div>
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<br /></div>
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<b style="mso-bidi-font-weight: normal;"><u>There Are No Silver Linings with Natural
Disasters<o:p></o:p></u></b></div>
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<br /></div>
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In recent weeks, the U.S. has experienced two natural
disasters – Hurricanes Harvey and Irma. Much real property was damaged or
destroyed by these two hurricanes. There will be an increase in construction
expenditures to repair and replace damaged/destroyed buildings and homes. There
will be an increase in motor vehicle expenditures to replace those destroyed by
the hurricanes. There is a natural strawberry-blonde (at least, that is her
claim) economist based in Chicago who, in the past, was wont to talk about the
increase in replacement expenditures following property-destroying natural
disasters as economic silver linings.<span style="mso-spacerun: yes;">
</span>She is not alone among economic analysts in making such a ridiculous
argument. In their narrow view, natural disasters “stimulate” aggregate demand.
If this view is correct, why wait for random natural disasters to hit? Why not
just send in the U.S. Air Force to carpet bomb selected U.S. neighborhoods to
prompt increased expenditures? If this view were correct, the U.S. Air Force
could play a constructive role in countering U.S. economic recessions! Who
needs the Fed anymore?<o:p></o:p></div>
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<br /></div>
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But, of course, there are no silver linings with natural
disasters. Yes, following natural disasters there is an increase in
expenditures to replace damaged real property. But there is a corresponding
decrease in discretionary expenditures. After all, the victims of natural
disasters cannot spend more than their incomes unless they increase their
borrowing. And if they increase their borrowing, the lender has to reduce his
current spending in order to finance the loans. If the government increases its
borrowing to make loans to the natural disaster victims or to make direct
replacement expenditures, again, the lenders to the government have to cut back
on their current expenditures. In sum, the replacement expenditures that take
place after natural disasters do not increase current expenditures in the
aggregate. Rather, replacement expenditures increase while more discretionary
expenditures decrease. <o:p></o:p></div>
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Lastly and perhaps most importantly, natural disasters
destroy real productive assets or capital. These assets came into existence in
the first place through saving – using resources currently to produce capital
assets that would produce <i style="mso-bidi-font-style: normal;">future </i>goods
and services for people to consume and enjoy. The current production of capital
assets involves delayed gratification of consumption. The destruction of
capital assets by natural disasters implies that we must again delay
consumption gratification in order to replace productive assets.<o:p></o:p></div>
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<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
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Founder, Econtrarian, LLC<o:p></o:p></div>
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<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com10tag:blogger.com,1999:blog-3399546775946309435.post-48173245232637040582017-08-02T09:13:00.000-07:002017-08-02T09:13:35.268-07:00Consumer Spending – I’ll Bet that Q3 Real GDP Growth Will Be Closer to Q1’s than Q2’s<div align="right" class="MsoNoSpacing" style="text-align: right;">
August 1, 2017<o:p></o:p></div>
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<br /></div>
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<b style="mso-bidi-font-weight: normal;"><u>Consumer Spending – I’ll Bet that Q3
Real GDP Growth Will Be Closer to Q1’s than Q2’s<o:p></o:p></u></b></div>
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<br /></div>
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It’s too hot to go sailing today, so I thought I’d
“unpack”, as the kids on cable news say, second quarter real GDP and real
personal consumption growth (PCE). I will argue that the quarter-to-quarter
acceleration in the growth of both second quarter real GDP and real PCE was due
more to arithmetic than a fundamental acceleration in the growth of aggregate
demand. To refresh your memory, real GDP annualized growth in the second
quarter was 2.6% <i style="mso-bidi-font-style: normal;">versus </i>1.2% in the
first quarter. Real PCE growth annualized growth in the second quarter was 2.8%
<i style="mso-bidi-font-style: normal;">versus </i>1.9% in the first quarter.<o:p></o:p></div>
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<br /></div>
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Let’s take a look at the month-to-month annualized real
PCE growth over the first six months of 2017 (see Chart 1). The median
month-to-month <i style="mso-bidi-font-style: normal;">annualized</i> real PCE
growth during this time period was a paltry 0.6%. The outlier during this
period was March, when annualized real PCE growth was a whopping 9.2%. The
annualized growth rate of real PCE in April, May and June were 0.20%, 2.20% and
0.45%, respectively. The three-month average of the annualized growth rates of
real PCE for April, May and June was 1.15%, a far cry from the 2.8% annualized
growth in the quarterly average <i style="mso-bidi-font-style: normal;">level</i>
of real PCE.<o:p></o:p></div>
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Chart 1<o:p></o:p></div>
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<a href="https://1.bp.blogspot.com/-M5Mds3_gWT4/WYH5nk0E-3I/AAAAAAAABGM/v0HSqRrPt_AiOReCPkXEVnsARYkdp75qACEwYBhgL/s1600/Consumer%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="454" data-original-width="975" height="298" src="https://1.bp.blogspot.com/-M5Mds3_gWT4/WYH5nk0E-3I/AAAAAAAABGM/v0HSqRrPt_AiOReCPkXEVnsARYkdp75qACEwYBhgL/s640/Consumer%2BChart%2B1.png" width="640" /></a></div>
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It was the surge in real PCE growth at the <i style="mso-bidi-font-style: normal;">end </i>of the first quarter that boosted
second-quarter real PCE growth. Plotted in Chart 2 are the monthly<i style="mso-bidi-font-style: normal;"> levels</i> of seasonally-adjusted at annual
rates of real PCE along with their three-month averages for the first six
months of 2017. Let’s concentrate on the data points for March and June. The three-month
averages of the PCE levels for March and June also are the first and second <i style="mso-bidi-font-style: normal;">quarterly </i>averages, respectively, of the
levels of real PCE. If you do the arithmetic you will find the March level of
real PCE was 0.49% higher than the average level of real PCE for the three
months ended March or the first-quarter average level of real PCE. If the level
of real PCE had simply remained at its March level in April, May and June, the
second-quarter average level of real PCE would have been equal to that of the
March level. In this case, annualized growth in second-quarter real PCE would
have been 1.97% (1.0049 raised to the fourth power and so on and so forth). <b style="mso-bidi-font-weight: normal;">Because the March level of real PCE was so
far above the first-quarter average, this biased upward the second-quarter
average level of real PCE and thus, second-quarter annualized growth in real
PCE.</b> But what March giveth, June taketh away. The June level of real PCE
was only 0.085% above the average level of real PCE for the three months ended
June, or the second-quarter average. If the level of real PCE were to remain at
the June level in July, August and September, then <i style="mso-bidi-font-style: normal;">annualized</i> growth in real PCE in the third quarter would be only <b style="mso-bidi-font-weight: normal;">0.3%! </b>So, while second-quarter
annualized growth in real PCE started the quarter with a strong tailwind,
third-quarter growth is starting with hardly any wind at its back. In order for
annualized growth in third-quarter real PCE to match the second quarter’s 2.8%
growth, the month-to-month annualized changes in real PCE would have to be
about 1.2%, <b style="mso-bidi-font-weight: normal;">double that of the median month-to-month
annualized percentage changes in the second quarter</b>. <o:p></o:p></div>
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Chart 2<o:p></o:p></div>
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<a href="https://1.bp.blogspot.com/-3WuYeF_HzhU/WYH51NUMQ-I/AAAAAAAABGQ/sjcjnKubD1M7S8ZLxr6KmqCPhM4CD4cagCLcBGAs/s1600/Consumer%2BChart%2B2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="405" data-original-width="975" height="264" src="https://1.bp.blogspot.com/-3WuYeF_HzhU/WYH51NUMQ-I/AAAAAAAABGQ/sjcjnKubD1M7S8ZLxr6KmqCPhM4CD4cagCLcBGAs/s640/Consumer%2BChart%2B2.png" width="640" /></a></div>
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Real PCE contributed 1.9 percentage points to the second
quarter’s 2.6% annualized growth in real GDP. If growth in real PCE slows in
the third quarter, which quarterly-averaging arithmetic suggests it will, then
growth in third-quarter real GDP is likely to slow, too. But there also is a
fundamental reason why third-quarter real PCE growth is likely to slow – you
guessed it, sluggish growth in thin-air credit. Plotted in Chart 3 are monthly
observations of the behavior of the sum of bank credit and the monetary base.
The bars are the year-over-year percent changes in monthly thin-air credit. The
line traces the month-to-month annualized percent changes in thin-air credit. In
June, the year-over-year percent change in thin-air credit was 2.6%, the
slowest growth in 12 months. In June, thin-air credit <b style="mso-bidi-font-weight: normal;">contracted</b> at an annualized rate of 0.4% <i style="mso-bidi-font-style: normal;">versus </i>May. Sluggish growth in thin-air credit is <b style="mso-bidi-font-weight: normal;">not </b>the stuff of robust growth in
consumer spending.<o:p></o:p></div>
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Chart 3<o:p></o:p></div>
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<a href="https://4.bp.blogspot.com/-_XxVqG_WBcA/WYH5761Le1I/AAAAAAAABGU/G0Kqx1JK75A05ELCyTmJb0M0DI6kCi5pACLcBGAs/s1600/Consumer%2BChart%2B3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="418" data-original-width="975" height="274" src="https://4.bp.blogspot.com/-_XxVqG_WBcA/WYH5761Le1I/AAAAAAAABGU/G0Kqx1JK75A05ELCyTmJb0M0DI6kCi5pACLcBGAs/s640/Consumer%2BChart%2B3.png" width="640" /></a></div>
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If the Fed does, in fact, begin paring its outright
holdings of securities in September, then it had better start engaging in
repurchase agreements. Otherwise the monetary base will shrink and, all else
the same, there will be upward pressure on the federal funds rate. If the
monetary base shrinks, thin-air credit growth will slow further unless there is
an offsetting increase in bank credit. If thin-air credit growth slows further
in the months ahead, investment-grade bond yields will fall more from their
already-low levels – barring a Treasury default emanating from a failure to
raise the federal government debt ceiling.<o:p></o:p></div>
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<br /></div>
<div class="MsoNoSpacing">
Lastly, my former Northern Trust colleague, Asha
Bangalore, has announced her retirement. Her last day at Northern will be
August 14. Asha joined me at Northern in 1994. Any success I might have had at
Northern was, in large part, due to having Asha as a colleague. She was my “Radar”
O’Reilly, knowing what we needed and obtaining it long before I even thought of
it. I was always in awe of Asha’s time-management skills. Where as I am a
congenital procrastinator, Asha immediately tackles any project regardless of
how difficult or boring it might be. I was blessed to have had such a
knowledgeable and capable colleague as Asha. Asha, best wishes as you enter
this new phase of your life. Who knows, perhaps we can put the team together
again if you get bored in retirement?<o:p></o:p></div>
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<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, <a href="http://www.the-econtrarian.blogspot.com/">Econtrarian,
LLC</a><o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust Co.
of Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
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<br /></div>
<div class="MsoNormal">
<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte<o:p></o:p></b></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com97tag:blogger.com,1999:blog-3399546775946309435.post-15395383734257607132017-07-16T12:14:00.001-07:002017-07-16T12:14:18.456-07:00Have Bundesbank Agents Infiltrated the Fed?<div align="right" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: right;">
July 17, 2017<o:p></o:p></div>
<div align="right" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: right;">
<br /></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
<b style="mso-bidi-font-weight: normal;"><u>Have
Bundesbank Agents Infiltrated the Fed?<o:p></o:p></u></b></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
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.<o:p></o:p></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
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.<o:p></o:p></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<br /></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 1<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-5BYuXDvnmfw/WWu53i1CsAI/AAAAAAAABEY/9oSw_oyM3kkC-IEV-XArmF-veD4CfwwfACLcBGAs/s1600/Bundesbank%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="630" data-original-width="975" height="412" src="https://4.bp.blogspot.com/-5BYuXDvnmfw/WWu53i1CsAI/AAAAAAAABEY/9oSw_oyM3kkC-IEV-XArmF-veD4CfwwfACLcBGAs/s640/Bundesbank%2BChart%2B1.png" width="640" /></a></div>
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<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
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. <o:p></o:p></div>
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<br /></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 2<o:p></o:p></div>
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<a href="https://1.bp.blogspot.com/-JEXpPDjvrh0/WWu6CTVNkbI/AAAAAAAABEc/I_ukoh4sAgYJiV16ZJd1iL24ki6Jzu8RgCLcBGAs/s1600/Bundesbank%2BChart%2B2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="621" data-original-width="975" height="406" src="https://1.bp.blogspot.com/-JEXpPDjvrh0/WWu6CTVNkbI/AAAAAAAABEc/I_ukoh4sAgYJiV16ZJd1iL24ki6Jzu8RgCLcBGAs/s640/Bundesbank%2BChart%2B2.png" width="640" /></a></div>
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<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
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 <i style="mso-bidi-font-style: normal;">advanced</i> 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 <i style="mso-bidi-font-style: normal;">leads</i>
consumer inflation by two years. So, what is happening to thin-air credit
growth <i style="mso-bidi-font-style: normal;">today</i> has its maximum effect
on consumer inflation two years<i style="mso-bidi-font-style: normal;"> later</i>.
(This has important implications as to how U.S. monetary policy should be
conducted, but the discussion of this is for a later commentary.)<span style="mso-spacerun: yes;"> </span>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 <i style="mso-bidi-font-style: normal;">slow </i>in 2017 and 2018 compared with 2015 and 2016. <o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 3<o:p></o:p></div>
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<a href="https://4.bp.blogspot.com/-6u7-5hqRTZA/WWu6J80jwUI/AAAAAAAABEg/osemWZ2IUsUXRcXUfpjeHx65I14qomgnQCLcBGAs/s1600/Bundesbank%2BChart%2B3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="561" data-original-width="975" height="368" src="https://4.bp.blogspot.com/-6u7-5hqRTZA/WWu6J80jwUI/AAAAAAAABEg/osemWZ2IUsUXRcXUfpjeHx65I14qomgnQCLcBGAs/s640/Bundesbank%2BChart%2B3.png" width="640" /></a></div>
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<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
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 <i style="mso-bidi-font-style: normal;">lower</i> in recent years, slowing to 2.6%
in the 12 months ended June 2017. Notice also that the federal funds rate has
been trending <i style="mso-bidi-font-style: normal;">higher</i>. Coincidence? I
don’t think so.<o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 4<o:p></o:p></div>
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<a href="https://2.bp.blogspot.com/-Uijxg4vblmU/WWu6Pf8tA9I/AAAAAAAABEk/GTQ3po9kpWIFcSPvP48RgYHu_k7GfAEfgCLcBGAs/s1600/Bundesbank%2BChart%2B4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="461" data-original-width="975" height="302" src="https://2.bp.blogspot.com/-Uijxg4vblmU/WWu6Pf8tA9I/AAAAAAAABEk/GTQ3po9kpWIFcSPvP48RgYHu_k7GfAEfgCLcBGAs/s640/Bundesbank%2BChart%2B4.png" width="640" /></a></div>
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<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
In order for the Fed to push the federal funds rate higher, it must
reduce the <i style="mso-bidi-font-style: normal;">supply</i> of the monetary base
relative to the<i style="mso-bidi-font-style: normal;"> demand </i>for the
monetary base. Chart 5 shows that as the target level of the federal funds rate
was <i style="mso-bidi-font-style: normal;">increased</i> by one full percentage
point in the 19 months ended June 2017, the monetary base <i style="mso-bidi-font-style: normal;">contracted</i> by $308 billion.<o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 5<o:p></o:p></div>
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<a href="https://2.bp.blogspot.com/-ns1xFan1xhc/WWu6WEypnLI/AAAAAAAABEo/yXIoWs5Tk28fCu_vDKC17IAiY0zbwFkCwCLcBGAs/s1600/Bundesbank%2BChart%2B5.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="451" data-original-width="975" height="294" src="https://2.bp.blogspot.com/-ns1xFan1xhc/WWu6WEypnLI/AAAAAAAABEo/yXIoWs5Tk28fCu_vDKC17IAiY0zbwFkCwCLcBGAs/s640/Bundesbank%2BChart%2B5.png" width="640" /></a></div>
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<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
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.<o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 6<o:p></o:p></div>
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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 <i style="mso-bidi-font-style: normal;">rea</i>l 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 <i style="mso-bidi-font-style: normal;">contracted
</i>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).<o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 7<o:p></o:p></div>
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Chart 8<o:p></o:p></div>
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Chart 9<o:p></o:p></div>
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<br /></div>
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Chart 10<o:p></o:p></div>
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<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
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.<o:p></o:p></div>
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<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
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?<o:p></o:p></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<span style="mso-spacerun: yes;"> </span>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 <i style="mso-bidi-font-style: normal;">rule</i>
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 <a href="http://www.politico.com/story/2017/07/10/trump-fed-top-bank-cop-240377"><i style="mso-bidi-font-style: normal;"><span style="color: blue;">Politico</span></i></a><i style="mso-bidi-font-style: normal;"> </i>article, Quarles is in favor of the Fed
using the <a href="https://en.wikipedia.org/wiki/Taylor_rule"><span style="color: blue;">Taylor Rule</span></a> 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 <i style="mso-bidi-font-style: normal;">wrong</i> rule for
the Fed to adopt. Can you guess what might be involved in the rule I would
favor?<o:p></o:p></div>
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<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<a href="https://www.blogger.com/null" name="_gjdgxs"></a>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, “<a href="https://www.netflix.com/title/70301553">Rake</a>”. 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 50<sup>th</sup> anniversary gift from my wife, a beautifully restored
50-year old classic sailboat – a <a href="https://www.youtube.com/watch?v=wVRVMwZgXa8&t=92s"><span style="color: blue;">Pearson Commander 26</span></a>. I will try to be more
productive, but sailing season up here in tundraland lasts until early October!<o:p></o:p></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, <a href="http://www.the-econtrarian.blogspot.com/">Econtrarian,
LLC</a><o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust Co.
of Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNormal">
<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte<o:p></o:p></b></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com6tag:blogger.com,1999:blog-3399546775946309435.post-23003174029678475312017-04-05T19:18:00.002-07:002017-04-05T19:18:34.213-07:00Although the Recent Weakness in Bank Credit Growth May Not Be a Concern to Others, It Is to Me<div align="right" class="MsoNoSpacing" style="text-align: right;">
April 6, 2017<o:p></o:p></div>
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<br /></div>
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<b style="mso-bidi-font-weight: normal;"><u>Although the Recent Weakness in Bank
Credit Growth May Not Be a Concern to Others, It Is to Me<o:p></o:p></u></b></div>
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<br /></div>
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Starting around this past December, growth in commercial
bank credit (loans and securities) slowed precipitously (see Chart 1).
Annualized 13-week growth in bank credit of late is the slowest since the
summer of 2013. This weakening in bank credit growth has been noticed and
commented on by at least two economic analysts besides me – University of
Oregon economics professor <a href="http://economistsview.typepad.com/economistsview/2017/03/fed-watch-is-bank-lending-a-concern.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+EconomistsView+%28Economist%27s+View%29">Tim
Duy</a> and Goldman Sachs economist Spencer Hill. These two analysts have
concentrated on the weakness in <i style="mso-bidi-font-style: normal;">one
component </i>of bank credit – <i style="mso-bidi-font-style: normal;">commercial
and industrial(C&I) loans</i> – and concluded that there is nothing to get
excited about with respect to the pace in U.S economic activity. I do not share
their sanguine view. Notice that the data in Chart 2 show that the growth in
bank credit <i style="mso-bidi-font-style: normal;">excluding C&I loans</i>
also has slowed precipitously since this past December. <b style="mso-bidi-font-weight: normal;">If history is any guide, this weakening in bank credit growth <i style="mso-bidi-font-style: normal;">excluding C&I loans is</i> cause for
concern with regard to the pace of economic activity.</b><o:p></o:p></div>
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Chart 1<o:p></o:p></div>
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Chart 2<o:p></o:p></div>
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Professor Duy, employing sophisticated econometrics
techniques, elegantly corroborated what the Conference Board told us decades
ago – the behavior of commercial and industrial bank loans is a <i style="mso-bidi-font-style: normal;">lagging </i>indicator of economic activity.
What Professor Duy did not do was <i style="mso-bidi-font-style: normal;">explain</i>
in Dick and Jane (Mr. Pero, that was for you) or otherwise why this is the
case. As the data in Chart 3 show, percentage changes in business inventories
have a relatively high contemporaneous correlation (0.57) with percentage
changes in bank C&I loans. So, businesses rely heavily on bank loans to
finance their inventories. To understand why bank C&I loans are a <i style="mso-bidi-font-style: normal;">lagging</i> indicator of economic activity,
we need to understand the behavior of business inventories <i style="mso-bidi-font-style: normal;">relative</i> to business sales in the business cycle. As business sales
start to slow, inventory growth tends to picks up. This is shown in Chart 4. This
increase in inventory growth relative to sales growth typically is <i style="mso-bidi-font-style: normal;">in</i>voluntary. With slower growth in revenues,
businesses rely even more heavily on their banks to finance their higher involuntary
inventory builds. <o:p></o:p></div>
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So, a surge in inventories and C&I loans often is
associated with a slowdown in the growth of final demand for goods and
services. Hence, bank C&I loan growth often tens to <i style="mso-bidi-font-style: normal;">lag </i>growth in final demand for goods and services. That is, the
behavior of bank C&I loan growth provides more information as to where the overall
economy <i style="mso-bidi-font-style: normal;">has been</i> rather than where it
<i style="mso-bidi-font-style: normal;">is headed</i>.<o:p></o:p></div>
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Chart 3<o:p></o:p></div>
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Chart 4<o:p></o:p></div>
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Goldman’s Mr. Hill hypothesized that the recent weakness
in bank C&I loan growth was due to the re-opening of the bond markets to
oil and gas industry borrowers. According to Mr. Hill, when energy prices fell
in 2015 and 2016 (obviously due to the anticipation of a Trump administration
that would promote oil/gas exploration and the elimination of environmental
regulations), oil and gas producers had to tap their bank lines of credit
because bond-market lenders became more wary. According to Mr. Hill, then, the
recent weakness in bank C&I loan growth is largely attributable to a more
receptive bond market toward oil and gas industry borrowers and does not signal
an imminent slowdown in U.S real GDP growth from its blistering Q4:2016
annualized pace of 2.1%.<o:p></o:p></div>
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<br /></div>
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And I agree with Messrs. Duy and Hill that the recent
slowdown in bank C&I growth is <i style="mso-bidi-font-style: normal;">not</i>
alarming with regard to the future course of U.S. economic activity. But I
believe bank C&I loan growth is a red herring with regard to the future
course of the economy. Instead, I focus on the growth in bank credit <i style="mso-bidi-font-style: normal;">excluding </i>the C&I loan component.
And as I mentioned at the outset of this commentary, growth in bank credit ex
C&I loans also has weakened precipitously starting in December 2016. <o:p></o:p></div>
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<br /></div>
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I am arguing that thin-air credit growth (you knew it was
coming) <i style="mso-bidi-font-style: normal;">excluding </i>C&I loans is a <i style="mso-bidi-font-style: normal;">better leading </i>indicator of the pace of
domestic demand than is thin-air credit growth<i style="mso-bidi-font-style: normal;"> including</i> C&I loans. I will demonstrate this to you by
comparing changes in correlation coefficients when thin-air credit <i style="mso-bidi-font-style: normal;">leads</i> and <i style="mso-bidi-font-style: normal;">lags</i> growth in domestic demand. Plotted in Chart 5 are
year-over-year percent changes in quarterly observations of the sum of depository
institution credit (including C&I loans) and the monetary base (the sum of
depository institution reserves at the Fed and currency) along with
year-over-year percentage changes in quarterly observations of Gross Domestic
Purchases. The <i style="mso-bidi-font-style: normal;">contemporaneous </i>correlation
coefficient between these two series is relatively high 0.61. (Remember, a
perfect correlation is 1.00). Plotted in Chart 6 is the same thing except that C&I
loans are <i style="mso-bidi-font-style: normal;">excluded </i>from the thin-air
credit growth aggregate. The <i style="mso-bidi-font-style: normal;">contemporaneous</i>
correlation coefficient between growth in thin-air credit growth <i style="mso-bidi-font-style: normal;">excluding </i>C&I loans and growth in
Gross Domestic Purchases is 0.55 – not bad for private-sector analysis, but
less than the 0.61 correlation coefficient when C&I loans are <i style="mso-bidi-font-style: normal;">included </i>in thin-air credit growth.<o:p></o:p></div>
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Chart 5<o:p></o:p></div>
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Chart 6<o:p></o:p></div>
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Remember, though, I am trying to discern which measure of
thin-air credit growth is a better <i style="mso-bidi-font-style: normal;">leading</i>
indicator of economic activity – thin-air credit growth with C&I loans or
excluding C&I loans. So, we need to see what happens to correlation
coefficients when thin-air credit growth leads and lags Gross Domestic
Purchases growth. <i style="mso-bidi-font-style: normal;">Contemporaneous </i>correlation
coefficients tell us nothing about leading or lagging characteristics. Does
thin-air credit growth “cause” Gross Domestic Purchase growth or <i style="mso-bidi-font-style: normal;">vice versa</i>? When thin-air credit growth <i style="mso-bidi-font-style: normal;">including</i> C&I loans is advanced by
one quarter, implying that today’s thin-air credit growth “causes” tomorrow’s
Gross Domestic Purchases growth, the correlation coefficient <i style="mso-bidi-font-style: normal;">falls </i>from 0.61 to 0.59. When thin-air
credit growth <i style="mso-bidi-font-style: normal;">excluding</i> C&I loans
is advanced by one quarter, the correlation coefficient <i style="mso-bidi-font-style: normal;">rises</i> from 0.55 to 0.57. Now let’s retard thin-air credit growth by
one quarter, implying that Gross Domestic Purchase growth “causes” thin-air
credit growth. When we do this, we find the correlation coefficient for
thin-air credit growth <i style="mso-bidi-font-style: normal;">including</i>
C&I loans is 0.61, the same as its contemporaneous correlation coefficient
and <i style="mso-bidi-font-style: normal;">higher</i> than 0.59, its correlation
coefficient when thin-air credit growth <i style="mso-bidi-font-style: normal;">including
C&I </i>loans is advanced by one quarter. <b style="mso-bidi-font-weight: normal;">These changes in the correlation coefficient suggest that thin-air
credit growth <i style="mso-bidi-font-style: normal;">including </i>C&I loans
is a <i style="mso-bidi-font-style: normal;">lagging </i>indicator of economic
activity. </b>When thin-air credit growth <i style="mso-bidi-font-style: normal;">excluding</i>
C&I loans is retarded by one quarter, the correlation coefficient <i style="mso-bidi-font-style: normal;">falls </i>to 0.51 compared to its
contemporaneous level of 0.55 and its one-quarter-advanced level of 0.57. <b style="mso-bidi-font-weight: normal;">These changes in correlation coefficients
suggest that thin-air credit growth <i style="mso-bidi-font-style: normal;">excluding
</i>C&I loans is a <i style="mso-bidi-font-style: normal;">leading </i>indicator
of economic activity</b>.<o:p></o:p></div>
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<br /></div>
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By the way, in case you think that there might not be
much left of depository institution credit once C&I loans are excluded,
take a look at Chart 7. From 1952 through 2016, the median percentage of
nonfinancial business loans from depository institutions as a percent of total
depository institution credit was 14.7. In 2016, C&I loans accounted for
13.9% of total depository institution credit. So, C&I loans, although a
significant portion of total depository institution credit, are far from the
whole ball of wax.<o:p></o:p></div>
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<span style="mso-spacerun: yes;"> </span><o:p></o:p></div>
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Chart 7<o:p></o:p></div>
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Okay, now that I have established (beyond a shadow of
doubt?) that thin-air credit <i style="mso-bidi-font-style: normal;">excluding</i>
C&I loans is the better leading indicator of the two, let’s see how it has
been behaving on a year-over-year basis in recent weeks and months. This is
shown in Chart 8. Although year-over-year growth in weekly observations of
commercial bank credit <i style="mso-bidi-font-style: normal;">excluding</i>
C&I loans has been slowing since October 2016, there has been some
acceleration in the growth of <i style="mso-bidi-font-style: normal;">combined</i>
bank credit ex C&I loans and the monetary base in recent weeks. Mind you,
at 3.4% in the 52 weeks ended March 22, growth in this version of thin-air
credit still is weak in an historical context.<span style="mso-spacerun: yes;">
</span>If commercial bank credit is not boosting <i style="mso-bidi-font-style: normal;">modestly </i>the growth rate of thin-air credit of late, it must be the
monetary base. As can be seen in Chart 9, one important factor that has been
increasing the monetary base since January is the decline in Treasury deposits
at the Fed. All else the same, when these deposits decline, depository
institution reserves increase. But as the April 15 tax payment date approaches,
Treasury revenues will spike up. To the degree that these revenues are
transferred to the Fed, all else the same, the monetary base will decline. In
addition, when the Fed raises the federal funds rate, it has to reduce the
supply of reserves in order to push up the interest rate. In sum, I would
expect that in coming weeks the monetary base will be contracting. Unless there
is a resurgence in bank credit growth, total thin-air credit growth will slow
from an already tepid pace.<o:p></o:p></div>
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<br /></div>
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<br /></div>
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Chart 8<o:p></o:p></div>
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Chart 9<o:p></o:p></div>
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On January 17, I published a commentary entitled “<a href="http://the-econtrarian.blogspot.com/2017/01/">2017 – Shades of 1937</a>”.
In the commentary, I wrote: “Based on the recent slowdown in thin-air credit
growth, I believe that a significant slowdown in the growth of nominal and real
U.S. domestic demand will commence in the first quarter of 2017.” Perhaps
“significant” was too strong an adjective, but I hold by my prediction of a
slowdown in the growth of real domestic demand. Despite relatively strong
employment gains in January and February and hinted at by the March ADP
employment guesstimate, real GDP growth in Q1:2017 appears to have come in at
an even weaker pace than that of the paltry 2.1% annualized in Q4:2016. (Perhaps
the depths of the productivity labor pool are being plumbed, requiring a larger
quantity of workers to get a given amount of output produced.) The Federal
Reserve Bank of Atlanta’s <a href="https://www.frbatlanta.org/cqer/research/gdpnow.aspx?panel=1">GDPNow</a>
Q1:2017 real GDP annualized growth estimate as of April 4 is 1.2%. Of course,
this does not yet incorporate March data. Real personal consumption, which has
accounted for about 68% of total real GDP in recent years, is coming in weak
based on January and February readings. If the March level of real personal
consumption were to be unchanged from the February level, Q1:2017 real personal
consumption will have grown at an <i style="mso-bidi-font-style: normal;">annualized</i>
pace of 0.3% -- not 3.0%, but <i style="mso-bidi-font-style: normal;">0</i>.3%.
In order for Q1:2017 real personal consumption expenditures to grow at the 3.5%
annualized pace of Q4:2016, March real personal consumption would have to grow
at annualized rate of 9.75% vs. February. <span style="mso-spacerun: yes;"> </span>How likely is this given that from January
2010 through February 2017 there have been only two month when real consumption
expenditures grew by at least 9% annualized month-to-month? The median
month-to-month annualized growth in real personal consumption from January 2010
through February 2017 has been 2.3%. If March real personal consumption were to
grow at an annualized 2.3%, this would imply Q1:2017 real personal consumption
growth of only 1.1%. <span style="mso-spacerun: yes;"> </span>What is arguing
against a strong reading of Q1:2017 real personal consumption growth is the
annualized 17.1% Q1:2017 <i style="mso-bidi-font-style: normal;">contraction</i> in
unit sales of light motor vehicles, the largest quarterly contraction since the
30.2% contraction in Q4:2009, the quarter after the federal “cash-for-clunkers”
program that boosted motor vehicle sales.<o:p></o:p></div>
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<br /></div>
<div class="MsoNoSpacing">
In conclusion, with or without C&I loans, thin-air
credit growth remains weak. Weak thin-air credit growth implies weak growth in domestic
demand. If the Fed does raise its federal funds rate target a couple of more
times this year as it has indicated it might, this would weaken thin-air credit
growth further and would likely bring on a recession. My bet is after seeing
the weakness in Q1:2017 real GDP growth and the lack of rebound in early
Q2:2017, the Fed will hold its fire.<o:p></o:p></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, <a href="http://www.the-econtrarian.blogspot.com/">Econtrarian,
LLC</a><o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust Co.
of Neenah, WI</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNormal">
<b style="mso-bidi-font-weight: normal;">“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte<o:p></o:p></b></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com25tag:blogger.com,1999:blog-3399546775946309435.post-41396134986617956672017-03-06T11:12:00.001-08:002017-03-06T11:12:14.388-08:00Do You Want to Restore Manufacturing Employment? Smash the Robots!<div align="right" class="MsoNoSpacing" style="text-align: right;">
March 6, 2017<o:p></o:p></div>
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<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<b style="mso-bidi-font-weight: normal;"><u>Do You Want to Restore Manufacturing
Employment? Smash the Robots!<o:p></o:p></u></b></div>
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<br /></div>
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There has been much public discussion about the demise of
U.S. manufacturing jobs and policies to restore manufacturing employment.
Indeed, as shown in Chart 1, in absolute as well as relative terms, U.S. manufacturing
employment has declined in the post-WWII era. In absolute terms, U.S.
manufacturing employment started falling precipitously in the 2000s and has
been especially hard hit since the Great Recession.<span style="mso-spacerun: yes;"> </span>(Shaded areas in this and subsequent charts
represent periods of economic recession.) U.S. manufacturing employment
relative to total U.S. nonfarm employment has been trending lower throughout
almost the entire post-WWII era. While relative manufacturing employment has
been trending lower for almost 70 years, <span style="mso-spacerun: yes;"> </span>manufacturing’s<i style="mso-bidi-font-style: normal;"> relative contribution </i>to total real GDP (see Chart 2), after
ebbing during the 1980s and early 1990s, staged a resurgence in late 1990s
until the Great Recession. Although foreign trade is being advanced by some as
the reason for the secular decline in U.S. manufacturing, I will argue that
technology is the principal factor accounting for this phenomenon.<o:p></o:p></div>
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Chart 1<o:p></o:p></div>
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Chart 2<o:p></o:p></div>
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<a href="https://4.bp.blogspot.com/-UjaLN1zwhZY/WL20IL0rp5I/AAAAAAAABBM/Wibw7mjGEzgAqh1NkKcCum_iwxqQ23qjACLcB/s1600/Smash%2BRobots%2BChart%2B2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="258" src="https://4.bp.blogspot.com/-UjaLN1zwhZY/WL20IL0rp5I/AAAAAAAABBM/Wibw7mjGEzgAqh1NkKcCum_iwxqQ23qjACLcB/s640/Smash%2BRobots%2BChart%2B2.png" width="640" /></a></div>
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Let’s examine the relationship between U.S. net exports
of <i style="mso-bidi-font-style: normal;">goods</i> and manufacturing output
relative to total output. Plotted in Chart 3 are annual averages of U.S. real <i style="mso-bidi-font-style: normal;">net </i>exports of durable goods (real
exports of goods minus real imports of goods) as a percent of total real GDP
and annual averages of real GDP value-added of manufacturing as a percent of
total real GDP. U.S. manufacturing output relative to total real GDP reaches a
post-WWII low in 1981 and climbs back to its highest level since 1972 in 2006.
Notice that as U.S. manufacturing relative GDP was oscillating <i style="mso-bidi-font-style: normal;">higher</i> from the early 1980s through the
mid 2000s, the U.S. real net exports in durable goods relative to real GDP was <i style="mso-bidi-font-style: normal;">oscillating lower</i>. For historical reference,
NAFTA was signed in 1994, the U.S. joined the WTO in 1995 when it came into
existence and Mainland China joined the WTO in December 2001.<b style="mso-bidi-font-weight: normal;"> So, U.S. manufacturing started making
greater contributions to total GDP <i style="mso-bidi-font-style: normal;">after </i>NAFTA
and <i style="mso-bidi-font-style: normal;">after</i> Mainland China joined the
WTO. That is, U.S. manufacturing started making <i style="mso-bidi-font-style: normal;">greater</i> contributions to total GDP as the U.S. trade deficit in durable
goods was <i style="mso-bidi-font-style: normal;">enlarging</i> </b>up until the
Great Recession.<o:p></o:p></div>
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Chart 3<o:p></o:p></div>
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<a href="https://4.bp.blogspot.com/-hfYIrl30og4/WL20PMhN4QI/AAAAAAAABBQ/xSH49ewD6K8tBTjMPHHh8dApikik6XyIACLcB/s1600/Smash%2BRobots%2BChart%2B3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="314" src="https://4.bp.blogspot.com/-hfYIrl30og4/WL20PMhN4QI/AAAAAAAABBQ/xSH49ewD6K8tBTjMPHHh8dApikik6XyIACLcB/s640/Smash%2BRobots%2BChart%2B3.png" width="640" /></a></div>
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So if foreign trade deficits are not a satisfactory
explanation of the secular decline in U.S. manufacturing employment, what is? A
secular increase in manufacturing-worker productivity. The data in Chart 4 compare
the real GDP value-added of manufacturing per manufacturing employee, a crude
measure of manufacturing-worker productivity, with the total number of
manufacturing employees. Both series are converted to index numbers with their
respective 1950 values set equal 100. If manufacturing workers are becoming
more productive over time, that is, as time progresses, one manufacturing
employee is able to produce a greater real value of manufacturing output than
in previous years, the index number of the real GDP value-added of
manufacturing per manufacturing employee would be higher. In fact, in 2015,
this index number stood at 776. This means that a manufacturing worker in 2015
could produce 676% more output than she could in 1950 (776 represents a 676%
increase vs. 100). This translates into a compound annual rate of growth in
this crude measure of manufacturing-worker productivity of 3.25% from 1950
through 2015. The index number of total manufacturing employment in 2015 stood
at 88, meaning that there were 12% fewer manufacturing employees then compared
to 1950 (88 represents a 12% decline vs. 100). Given the secular increase in
manufacturing-worker productivity, it is not surprising that there has been a
secular decline in the number of people employed in manufacturing.<o:p></o:p></div>
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Chart 4<o:p></o:p></div>
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<a href="https://4.bp.blogspot.com/-2ULiD44M0H0/WL20Wl9zyvI/AAAAAAAABBU/gYKt1ec1Y0k1P2TJLvP_11e9-t4d11PeQCLcB/s1600/Smash%2BRobots%2BChart%2B4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="284" src="https://4.bp.blogspot.com/-2ULiD44M0H0/WL20Wl9zyvI/AAAAAAAABBU/gYKt1ec1Y0k1P2TJLvP_11e9-t4d11PeQCLcB/s640/Smash%2BRobots%2BChart%2B4.png" width="640" /></a></div>
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<div class="MsoNoSpacing">
The data in Chart 5 help explain the secular increase in
manufacturing-worker productivity. Along with the index of real GDP value-added
of manufacturing per manufacturing employee, again a crude measure of
manufacturing-worker productivity, I have added the index of the real net stock
of business equipment per manufacturing employee – a crude measure of the
capital-to-labor ratio in manufacturing. Give a woman a brace-and-a bit set,
and she can drill more holes in a given amount of time. Give a woman an
electric drill, and she can drill even more holes in the same amount of time.
Give a woman a drilling robot to run, and she can drill yet even more holes in
the same amount of time. In other words, the more equipment and more technologically-advanced
equipment a manufacturing worker has to work with, the more output can be
produced by that worker in a given amount of time. As the capital-to-labor
ratio in manufacturing rises, so should worker productivity rise. And that is
what the data plotted in Chart 5 indicate.<o:p></o:p></div>
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Chart 5<o:p></o:p></div>
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<a href="https://3.bp.blogspot.com/-Ub1NZROUoSI/WL20dB8smjI/AAAAAAAABBY/d_XKNEONEEUF1kfBizk970FlwXxPn3_rgCLcB/s1600/Smash%2BRobots%2BChart%2B5.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="298" src="https://3.bp.blogspot.com/-Ub1NZROUoSI/WL20dB8smjI/AAAAAAAABBY/d_XKNEONEEUF1kfBizk970FlwXxPn3_rgCLcB/s640/Smash%2BRobots%2BChart%2B5.png" width="640" /></a></div>
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<br /></div>
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<br /></div>
<div class="MsoNoSpacing">
The moral of this story is that if America wants to
restore manufacturing employment to its former glory, the federal government
should form a search-and-destroy task force with the authority to enter
manufacturing facilities in the U.S. to smash robots, computers and any other
labor-saving equipment the deputized task force deems appropriate. Then there
will be a tremendous increase in demand for U.S. manufacturing employees. <b style="mso-bidi-font-weight: normal;">Of course, manufacturing output will grow
more slowly and the prices of manufactured goods will skyrocket</b>. But, hey,
the goal of increased manufacturing employment will have been achieved.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Co. of Neenah, WI</a><span class="MsoHyperlink"><o:p></o:p></span></div>
<div class="MsoNoSpacing">
<span class="MsoHyperlink"><a href="http://www.the-econtrarian.blogspot.com/">The Econtrarian</a><o:p></o:p></span></div>
<div class="MsoNoSpacing">
<span class="MsoHyperlink"><a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></span></div>
<div class="MsoNoSpacing">
<span class="MsoHyperlink">1-920-818-0236<o:p></o:p></span></div>
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“For most of human history, it made good adaptive sense to
be fearful and emphasize the negative; any mistake could be fatal”, Joost
Swarte<o:p></o:p></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com65tag:blogger.com,1999:blog-3399546775946309435.post-80346937164817284182017-01-17T10:28:00.001-08:002017-12-29T13:12:50.516-08:002017 -- Shades of 1937<div align="right" class="MsoNoSpacing" style="text-align: right;">
January 17, 2017<o:p></o:p></div>
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<b style="mso-bidi-font-weight: normal;"><u>2017 – Shades of 1937<o:p></o:p></u></b></div>
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<br /></div>
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As a result of some Fed actions taken in 1936 and 1937,
the U.S. economy, after experiencing a robust economic recovery starting in
early 1934, slipped back into a recession midyear 1937, which lasted through
midyear 1938. Based on the recent slowdown in thin-air credit growth, <span style="mso-spacerun: yes;"> </span>I believe that a significant slowdown in the
growth of nominal and real U.S. domestic demand will commence in the first
quarter of 2017. The duration and magnitude of this slowdown depends on the
future behavior of thin-air credit. <o:p></o:p></div>
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Let’s briefly review the U.S. monetary history of
1936-1938. In response to the robust recovery the U.S. economy was experiencing
and the high level of excess reserves the banking system was maintaining, the
Fed, in a series of steps between August 1936 and May 1937, <i style="mso-bidi-font-style: normal;">doubled</i> the percentage of cash reserves
banks were <i style="mso-bidi-font-style: normal;">required</i> to hold against
their deposits. The Fed believed that these <i style="mso-bidi-font-style: normal;">de
jure</i> excess reserves held by banks were <i style="mso-bidi-font-style: normal;">de
facto</i> excess reserves. That is, the Fed did <i style="mso-bidi-font-style: normal;">not</i> believe that banks <i style="mso-bidi-font-style: normal;">desired</i>
to hold the amount of <i style="mso-bidi-font-style: normal;">de jure</i> excess
reserves that were in existence. If these reserves held by banks truly were in
excess of what they wanted to hold, then it was surmised by the Fed that banks
would engage in the creation of new credit for the economy by some multiple of
the existing excess reserves. If this creation of new bank credit were to occur
against a backdrop of an already robust economic expansion, the U.S. economy
would be in danger of overheating.<span style="mso-spacerun: yes;"> </span>As a
result of this reasoning, the Fed chose to “sterilize” some of these excess
reserves by converting them into <i style="mso-bidi-font-style: normal;">required
</i>reserves.<o:p></o:p></div>
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As it turned out, with the experience of bank runs of the
early 1930s still fresh in the memory of bank managers, a large proportion of
the existing excess reserves were, in fact, desired to be held by banks. As a
result, when the Fed decreed that a large portion of these excess reserves
would become required reserves, banks attempted to restore their holdings of
excess reserves. In this attempt, banks <i style="mso-bidi-font-style: normal;">contracted
</i>their loans and investments – bank credit. Because only the Fed can
increase or decrease total reserves, this banking <i style="mso-bidi-font-style: normal;">system </i>contraction in bank credit did not, in and of itself, increase
total reserves. But what it did do was contract bank deposits, which in turn,
reduced <i style="mso-bidi-font-style: normal;">required </i>reserves. For a
given amount of total reserves, a reduction in required reserves implies an
increase in excess reserves. Following the contraction in bank credit and the
sharp slowdown in the growth of bank reserves, the U.S. economy entered a
recession at midyear 1937. In sum, the Fed’s decision back then to double the
reserve requirement ratio against bank deposits set in motion a sharp
deceleration in the growth of thin-air credit that resulted in a U.S.
recession.<o:p></o:p></div>
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<br /></div>
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Let’s fast forward about 80 years. The Fed has not raised
required reserve ratios. But, as shown in Chart 1, the Fed has begun
contracting an element of thin-air credit, the monetary base (cash reserves
held by depository institutions plus currency in circulation). In 2014, the Fed
began tapering its purchases of securities in the open market, which slowed the
growth in the monetary base. In 2015, the Fed ceased altogether its securities
purchase program and contracted the monetary base at the end of 2015 in order
to push up the federal funds rate by 25 basis points. For reasons still a
mystery to me, the Fed stepped up its contraction in the monetary base in the
second half of 2016, culminating in a further contraction in December 2016 in
order to push up the federal funds rate another 25 basis points.<o:p></o:p></div>
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Chart 1<o:p></o:p></div>
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<a href="https://4.bp.blogspot.com/-W2k7Adifg1o/WH5hwSXXgMI/AAAAAAAAA_U/dl6Qxd-ogGwBa6k7qouIM1B71FfmnnzAACLcB/s1600/2017%2Bv%2B1937%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="280" src="https://4.bp.blogspot.com/-W2k7Adifg1o/WH5hwSXXgMI/AAAAAAAAA_U/dl6Qxd-ogGwBa6k7qouIM1B71FfmnnzAACLcB/s640/2017%2Bv%2B1937%2BChart%2B1.png" width="640" /></a></div>
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<div class="MsoNoSpacing">
Another major element of thin-air credit, credit created
by commercial banks, after cruising along at robust growth rates in 2015 and
most of 2016, suddenly decelerated sharply in Q4:2016. I am not aware of any
new regulations or credit-quality concerns that would have motivated commercial
banks to slow their acquisitions of loans and securities. Yes, short-maturity
bank funding rates have crept up in the past two years in response to actual
and expected increases in the federal funds rate. For example, in the week
ended September 30, 2016, the average three-month LIBOR interest rate was 21
basis points higher than it was in the week ended July 1, 2016. If a 21 basis
point increase in bank funding costs caused the quantity <i style="mso-bidi-font-style: normal;">demanded</i> of bank credit to slow as much as it did in November and
December 2016, then the interest elasticity of bank credit demand is
extraordinarily high. And if, in fact, the interest sensitivity of bank credit
demand is so high, the Fed might want to take this into consideration in its
federal funds rate targets going forward.<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 2<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-G3wsGcO_iNw/WH5h5shMNOI/AAAAAAAAA_Y/seJWGzE_Bfc3ldmKoAXJLiXyGZJAC3NtwCLcB/s1600/2013%2Bv%2B1937%2BChart%2B2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="340" src="https://4.bp.blogspot.com/-G3wsGcO_iNw/WH5h5shMNOI/AAAAAAAAA_Y/seJWGzE_Bfc3ldmKoAXJLiXyGZJAC3NtwCLcB/s640/2013%2Bv%2B1937%2BChart%2B2.png" width="640" /></a></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
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<div class="MsoNoSpacing">
Okay, it is a mystery to me as to why the Fed contracted
the monetary base as much as it did in 2016 and why bank credit growth fell off
a cliff in Q4:2016, but as I amusingly remember hearing in so many corporate staff
meetings – it is what it is. So, let’s combine bank credit with the monetary
base to see what the behavior of this thin-air credit aggregate has been of
late. This is presented in Chart 3. On a year-over-year basis, growth in the
sum of commercial bank credit and the monetary base in December 2016 was 2.6%.
To put this into historical context, from January 1960 through December 2016,
the median year-over-year growth in monthly observations of the sum of
commercial bank credit and the monetary base was 7.1%. In the three months
ended December 2016, the annualized percentage change in this measure of
thin-air credit was <i style="mso-bidi-font-style: normal;">minus </i>0.6%.<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 3<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://2.bp.blogspot.com/-Qqb77h-LBVM/WH5iB5dEIJI/AAAAAAAAA_c/CgYHu0ncDyw6bPb4KWtkosqtlkWFcrkTQCLcB/s1600/2017%2Bv%2B1937%2BChart%2B3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="384" src="https://2.bp.blogspot.com/-Qqb77h-LBVM/WH5iB5dEIJI/AAAAAAAAA_c/CgYHu0ncDyw6bPb4KWtkosqtlkWFcrkTQCLcB/s640/2017%2Bv%2B1937%2BChart%2B3.png" width="640" /></a></div>
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<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
So, there has been a deceleration in the growth of this
measure of thin-air credit to a rate that is quite low compared to its longer-run
median rate. So what? Chart 4 provides an answer to this question. Plotted in
Chart 4 are year-over-year percent changes in quarterly observations of nominal
Gross Domestic Purchases and of the sum of commercial bank credit and the
monetary base. The year-over-year percent changes in the sum of commercial bank
credit and the monetary base are advanced by one quarter in order to be
consistent with my hypothesis that the behavior of thin-air credit leads or
“causes” the behavior of nominal Gross Domestic Purchases. Gross Domestic
Purchases are defined as Gross Domestic Product <i style="mso-bidi-font-style: normal;">minus </i>exports <i style="mso-bidi-font-style: normal;">plus</i>
imports. The correlation coefficient between these two series from Q1:2012
through Q3:2016 is 0.71. If these two series were perfectly correlated, the
correlation coefficient would be 1.00. So, although not a perfect relationship,
there does appear to be a relatively close positive relationship between
changes in this measure of thin-air credit and changes in nominal domestic
purchases of goods and services. With the year-over-year growth in this measure
of thin-air credit slowing from 3.9% in Q3:2016 to 2.6% in Q4:2016 (indicated
by the Q1:2017 blue bar in Chart 4 because growth in thin-air credit is
advanced by one quarter), this augurs poorly for growth in nominal Gross
Domestic Purchases in Q1:2017. <o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 4<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://2.bp.blogspot.com/-dfL9d32adQ8/WH5iLiLIknI/AAAAAAAAA_g/kgy5m00Z9gEO5zH8ihZWo6OVw8W408gYgCLcB/s1600/2017%2Bv%2B1937%2BChart%2B4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="334" src="https://2.bp.blogspot.com/-dfL9d32adQ8/WH5iLiLIknI/AAAAAAAAA_g/kgy5m00Z9gEO5zH8ihZWo6OVw8W408gYgCLcB/s640/2017%2Bv%2B1937%2BChart%2B4.png" width="640" /></a></div>
<div class="MsoNoSpacing">
<span style="mso-no-proof: yes;"><!--[if gte vml 1]><v:shape
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<div class="MsoNoSpacing">
If growth in U.S. domestic demand falters in Q1:2017, as
“predicted” by the recent behavior of thin-air credit, then the Fed is unlikely
to push the federal funds rate higher until it sees a recovery in demand
growth. Even if the Fed holds off on raising the federal funds rate, it still
is unlikely to step up growth in the monetary base component of thin-air credit
in Q1:2017. As mentioned above, I am at a loss to explain the recent sharp
deceleration in bank credit growth. But unless growth in this component of
thin-air credit does re-accelerate, then very weak growth in total thin-air credit
would likely persist through Q1:2017, which would have continued negative
implications for growth in domestic demand for goods and services into Q2:2017.
<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
The Fed’s actions of 1936-37 caused a sharp slowdown in
the growth of thin-air credit, which resulted in the recession of 1937-38. It
is too early for me to forecast a recession in 2017 because of the Fed’s
disregard for the recent growth slowdown in thin-air credit. But I do believe
investor expectations of U.S. economic growth will be disappointed in the first
half of 2017. All else the same, this economic-growth disappointment has
positive implications for U.S. investment grade bonds and negative implications
for risk assets such as U.S. equities.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
One factor that could stimulate thin-air credit growth
would be a sharp increase in federal credit demand resulting from tax cuts
and/or discretionary spending increases. This increased credit demand would put
upward pressure on the structure of U.S interest rates. If the Fed were
unwilling to allow the federal funds rate from rising under these
circumstances, then both the monetary base and bank credit would rise in the
face of the increased credit demand. It is not a question of <i style="mso-bidi-font-style: normal;">if</i> significant federal tax cuts are
coming in the next two years, but <i style="mso-bidi-font-style: normal;">when</i>
and <i style="mso-bidi-font-style: normal;">how</i> the Fed will react to them.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian, LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Co. of Neenah, Wisconsin</a><span class="MsoHyperlink"><o:p></o:p></span></div>
<div class="MsoNoSpacing">
<a href="http://www.the-econtrarian.blogspot.com/">The
Econtrarian</a><span class="MsoHyperlink"><o:p></o:p></span></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><span class="MsoHyperlink"><o:p></o:p></span></div>
<div class="MsoNoSpacing">
<span class="MsoHyperlink">1-920-818-0236<o:p></o:p></span></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNormal">
“For most of human history, it made good adaptive sense to
be fearful and emphasize the negative; any mistake could be fatal”, Joost
Swarte<o:p></o:p></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.comtag:blogger.com,1999:blog-3399546775946309435.post-82267805977739645562016-12-14T17:46:00.000-08:002016-12-14T17:46:09.980-08:00If You Think the Pace of Economic Activity Is Weak in 2016, Just Wait Until 2017<div align="right" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: right;">
December 14, 2016<o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
<br /></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
<b style="mso-bidi-font-weight: normal;"><u>If
You Think the Pace of Economic Activity Is Weak in 2016, Just Wait Until 2017</u></b><o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<a href="https://www.blogger.com/null" name="_gjdgxs"></a>As shown in Chart 1, the year-over-year growth in
real and nominal Gross Domestic Purchases (C+I+G) in Q3:2016 was 1.4% and 2.4%,
respectively. This compares with 2.8% and 4.7% year-over-year growth in real
and nominal Gross Domestic Purchases, respectively, in Q3:2014.<b style="mso-bidi-font-weight: normal;"> So the pace of real and nominal domestic
spending in the four quarters ended Q3:2016 was about half that of the pace in
the four quarters ended Q3:2014. </b>Notice the green line in Chart 1. It
represents the year-over-year percent change in quarterly-average observations
of the sum of commercial bank credit (loans and securities on the books of
commercial banks) and the monetary base (reserves held at the Fed by depository
institutions and currency in circulation). As regular readers (are there still
two of you?) of this commentary remember, this sum is what I refer to as
thin-air credit because it is credit that is created by the commercial banking
system and the Fed figuratively out of thin air. The unique characteristic of
thin-air credit is that no one else need cut back on his/her current spending
as the recipient of this credit increases his/her current spending. Notice that
growth in this measure of thin-air credit, as represented by the green line in
Chart 1, has been trending lower since hitting a post-recession peak in the
fourth quarter of 2014. Growth in thin-air credit is advanced by one quarter in
Chart 1 because my past research has shown that the highest correlation between
growth in thin-air credit and growth in nominal Gross Domestic Purchases is
obtained when growth in thin-air credit <i style="mso-bidi-font-style: normal;">leads</i>
growth in nominal Gross Domestic Purchases by one quarter. This suggests, but
by no means proves, that the behavior of thin-air credit has a <i style="mso-bidi-font-style: normal;">causal</i> relationship with the behavior of
growth in Gross Domestic Purchases. <b style="mso-bidi-font-weight: normal;">So,
I believe that the slowdown in the growth of thin-air credit in the past two
years has played a major role in the slowdown in domestic spending during this
period.</b><o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 1<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://1.bp.blogspot.com/-Bt-7gSIfM7I/WFH1ULH0EoI/AAAAAAAAA-Q/pgkP-ST1VPIIrxEqjheKWAM0HIRaC313wCEw/s1600/If%2BYou%2BThink%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="420" src="https://1.bp.blogspot.com/-Bt-7gSIfM7I/WFH1ULH0EoI/AAAAAAAAA-Q/pgkP-ST1VPIIrxEqjheKWAM0HIRaC313wCEw/s640/If%2BYou%2BThink%2BChart%2B1.png" width="640" /></a></div>
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<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
Chart 2 provides some insight as to why growth in the sum of commercial
bank credit and the monetary base has been slowing since 2014. The slowdown in
the growth of thin-air credit in the past two years is <i style="mso-bidi-font-style: normal;">not</i> because banks have been stingy with their granting of credit.
On the contrary, as can be seen in Chart 2, year-over-year growth in commercial
bank credit (the blue line), after accelerating sharply in 2014, held in a
range of about 6-1/2% to 7-3/4% in 2015 and over the first three quarters of
2016. So, despite the increased regulation that banks are now subject to, bank
credit growth has returned to a rate approximately equal to its long-run
median. No, the culprit has been the Fed. Growth in the monetary base (the
green bars in Chart 2), reserves and currency created by the Fed, decelerated
in 2014. There was essentially no growth in the monetary base in 2015 and there
has been a contraction in it so far in 2016. In 2014, the Fed began to taper
the amount of securities it had been purchasing in the open market in
connection with its third phase of quantitative easing (QE). This resulted in
the deceleration in the growth of the monetary base. In 2015, the Fed ceased
its QE operations. In December 2015, the Fed raised its federal funds rate
target by 25 basis points. In order to “enforce” this higher federal funds
rate, the Fed had to reduce the supply of reserves it created relative to
depository institutions’ demand. This resulted in the contraction in the
monetary base in early 2016. For reasons still a mystery to me, the Fed has
failed to offset the drain of reserves caused by unusually high Treasury
balances at the Fed. In addition, the Fed has been draining reserves from the
financial system via reverse repurchase agreements, presumably to satisfy the
money market mutual funds’ demand for risk-free assets as a result of
regulatory changes that when in effect in October 2016. (See my November 1,
2016 commentary <a href="http://the-econtrarian.blogspot.com/2016/11/the-fed-began-tightening-policy-in.html"><span style="color: blue;">“The Fed Began Tightening Policy in October and No One Knew
It, Maybe Not Even the Fed”</span></a> for a discussion of this.) This has
resulted in the continued contraction in the monetary base in 2016. <b style="mso-bidi-font-weight: normal;">In sum, the slowdown in the growth of
combined commercial bank credit and the monetary base in the past two years is
primarily the result of the Fed’s failure to create enough thin-air credit to
prevent the stagnation in monetary base in 2015 and the outright contraction in
the monetary base so far in 2016. And I would submit to you that the
significant deceleration in the growth in combined commercial bank credit and
the monetary base in 2015 and 2016 is primarily responsible for the
deceleration in the growth of both nominal and real Gross Domestic Purchases in
these years as well.</b><o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 2<o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-Fo44UlfCG1w/WFH1hwRWjhI/AAAAAAAAA-U/Vdn7TPkilRAORd3okugnecgqpHadKLuogCLcB/s1600/If%2BYou%2BThink%2BChart%2B2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="348" src="https://4.bp.blogspot.com/-Fo44UlfCG1w/WFH1hwRWjhI/AAAAAAAAA-U/Vdn7TPkilRAORd3okugnecgqpHadKLuogCLcB/s640/If%2BYou%2BThink%2BChart%2B2.png" width="640" /></a></div>
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<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
On December 14, 2016, the Fed raised its federal funds rate target by
another 25 basis points. Just as the Fed had to reduce the supply of reserves
relative to depository institutions’ demand for them in order to push the
federal funds rate up to its higher targeted level in December 2015, it will
have to do the same thing in December 2016. This implies a further contraction
in the monetary base. Chart 3 shows the year-over-year annual and three-month
annualized growth in combined commercial bank credit and the monetary base in
the past 12 months. <b style="mso-bidi-font-weight: normal;">In the 12 months
ended November 2016, growth in combined commercial bank credit and the monetary
base was 2.7%. In the three months ended November 2016, growth in combined
commercial bank credit and the monetary base was a goose egg – that is, zero.
To put the recent growth in this measure of thin-air credit into perspective,
from January 1960 through November 2016, the median year-over-year growth in
monthly observations of combined commercial bank credit and the monetary base
has been 7.1%. So, recent months’ growth in this measure of thin-air credit has
been exceptionally low, both in absolute as well as relative terms. <i style="mso-bidi-font-style: normal;">And, with the Fed’s December 14, 2016
decision to raise the federal funds rate another 25 basis points, growth in
combined commercial bank credit and the monetary base will be even weaker in
the coming months</i>.</b><o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 3<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-pgm91IDeEpI/WFH1pNiCXnI/AAAAAAAAA-Y/HZ3anrg05g0E_9LnteQpF-nSVaDTnWdGgCLcB/s1600/If%2BYou%2BThink%2BChart%2B3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="222" src="https://4.bp.blogspot.com/-pgm91IDeEpI/WFH1pNiCXnI/AAAAAAAAA-Y/HZ3anrg05g0E_9LnteQpF-nSVaDTnWdGgCLcB/s640/If%2BYou%2BThink%2BChart%2B3.png" width="640" /></a></div>
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<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
The extreme weakness in the growth in the past three months of combined
commercial bank credit and the monetary is <i style="mso-bidi-font-style: normal;">not</i>
just due to the contraction in the monetary base. As shown in Chart 4, there
also has been some weakening in the growth of commercial bank credit, too. To
wit, in the three months ended November 2016, the annualized growth in
commercial bank credit slowed to 5.6%, the slowest growth since the 5.7% posted
in the three months ended November 2015.<o:p></o:p></div>
<div align="center" class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in; text-align: center;">
Chart 4<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://1.bp.blogspot.com/-IA7_OIlaCbo/WFH1xeorzaI/AAAAAAAAA-c/Z5-M11dfGCA9PAUkwJAIWdnAiT3Gl2MbACLcB/s1600/If%2BYou%2BThink%2BChart%2B4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="230" src="https://1.bp.blogspot.com/-IA7_OIlaCbo/WFH1xeorzaI/AAAAAAAAA-c/Z5-M11dfGCA9PAUkwJAIWdnAiT3Gl2MbACLcB/s640/If%2BYou%2BThink%2BChart%2B4.png" width="640" /></a></div>
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<span style="mso-no-proof: yes;"><!--[if gte vml 1]><v:shape
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<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
Based on published data so far for Q4:2016, the Atlanta Fed is
forecasting real GDP annualized growth in this current quarter of 2.4%, down
from the previous quarter’s 3.2% annualized growth. With current growth in
thin-air credit already very weak and likely to get even weaker after the Fed
contracts the monetary base more in order to push the federal funds rate 25
basis points higher, real and nominal U.S. economic growth is likely to slow
further in the first half of 2017. Happy Festivus!<o:p></o:p></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<br /></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
Paul L. Kasriel<o:p></o:p></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
Founder, Econtrarian, LLC<o:p></o:p></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<a href="http://www.lptrust.com/"><span style="color: blue;">Legacy
Private Trust Co. of Neenah, Wisconsin</span></a><u><span style="color: blue;"><o:p></o:p></span></u></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<u><span style="color: blue;"><a href="http://www.the-econtrarian.blogspot.com/">The Econtrarian</a><o:p></o:p></span></u></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<u><span style="color: blue;"><a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></span></u></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<u><span style="color: blue;">1-920-818-0236<o:p></o:p></span></u></div>
<div class="normal" style="line-height: normal; margin-bottom: .0001pt; margin-bottom: 0in;">
<br /></div>
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<a href="http://www.lptrust.com/"></a><u><span style="color: blue;"><o:p></o:p></span></u></div>
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“For most of human history, it has made good adaptive
sense to be fearful and emphasize the negative; any mistake could be fatal”,
Joost Swarte<o:p></o:p></div>
Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com9tag:blogger.com,1999:blog-3399546775946309435.post-62895612228838879802016-11-20T15:54:00.001-08:002016-11-20T15:54:35.274-08:00Do Larger Deficits Stimulate Spending? Depends on Where the Funding Comes From<div align="right" class="MsoNoSpacing" style="text-align: right;">
November 21, 2016<o:p></o:p></div>
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<b style="mso-bidi-font-weight: normal;"><u>Do Larger Federal Budget Deficits
Stimulate Spending? Depends on Where the Funding Comes From<o:p></o:p></u></b></div>
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The U.S. equity markets have rallied in the wake of
Donald Trump’s presidential election victory. Various explanations have been
given for the stock market rally. President-elect Trump’s pledge to scale back
business regulations are favorable for various industries, especially financial
services and pharmaceuticals. Likewise, President-elect Trump’s vow to increase
military spending is an undeniable plus for defense contractors. But another
explanation given for the post-election stock market rally is that U.S.
economic growth will be stimulated by the almost certain business and personal
tax-rate cuts that will occur in the next year, along with the somewhat less
certain increase in infrastructure spending. It is this conventional –wisdom
notion that tax-rate cuts and/or increased federal government spending
stimulate domestic spending on goods and services that I want to discuss in
this commentary. <o:p></o:p></div>
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Although I have been a recovering Keynesian for decades,
I got hooked on the Keynesian proposition that tax-rate cuts and increased
government spending could stimulate domestic spending after having taken my
first macroeconomics course way back in 19 and 65. I was so intoxicated with
Keynesianism that I made a presentation about it in a political science class.
I dazzled my classmates with explanations of the marginal propensity to consume
and Keynesian multipliers. My conclusion was that economies need not endure
recessions if only policymakers would pursue Keynesian prescriptions with
regard to tax rates and government spending. Reading the body language of my
classmates, I believed that I had just enlisted a new cadre of Keynesians. That
is, until one older student sitting in the back of the class raised his hand
and asked the simple question: <b style="mso-bidi-font-weight: normal;">Where
does the government get the funds to pay for the increased spending or tax
cuts? </b>I had to call on all of my obfuscational talents to keep my
classmates and <i style="mso-bidi-font-style: normal;">me</i> in the Keynesian
camp. <o:p></o:p></div>
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When I graduated from college with a degree in economics,
I still was a Keynesian, perhaps a bit more sophisticated one, but not much. At
graduate school, I became less enchanted with Keynesianism. But Keynesianism is
similar to an incorrect golf grip. If you start out playing golf with an
incorrect grip, you will have a tendency to revert to it on the golf course
even after hours of practicing at the driving range with a correct grip. Bad
habits die hard. So, even though I had drifted away from Keynesianism, it was
easy and “comfortable” to slip back into a Keynesian framework when performing
macroeconomic analysis. Yet, I continued to be haunted by that question my
fellow student asked me: <span style="mso-spacerun: yes;"> </span><b style="mso-bidi-font-weight: normal;">Where does the government get the funds to
pay for the increased spending or tax cuts?</b><o:p></o:p></div>
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I guess I am a slow learner, but after a number of years
in the “real world”, away from the pressure of academic group-think, I realized
that tracing through the implications of <i style="mso-bidi-font-style: normal;">where</i>
the government gets the funds to finance tax-rate cuts and increased spending
is the most important issue in assessing the stimulative effect of changes in
fiscal policy. And my conclusion is that tax-rate cuts and increased government
spending do<i style="mso-bidi-font-style: normal;"> not</i> have a significant
positive <i style="mso-bidi-font-style: normal;">cyclical</i> effect on economic
growth and employment <i style="mso-bidi-font-style: normal;">unless the
government receives the funding for such out of “thin air”</i>.<o:p></o:p></div>
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Let’s engage in some thought experiments, beginning with
a net increase in federal government spending, say on infrastructure projects.
Let’s assume that these projects are funded by an increase in government bonds
purchased by households. Let’s further assume that the households increase
their <i style="mso-bidi-font-style: normal;">saving</i> in order to purchase
these new government bonds. When households save more, they cut back on their <i style="mso-bidi-font-style: normal;">current</i> spending on goods and services, <i style="mso-bidi-font-style: normal;">transferring</i> this spending power to
another entity, in this case the federal government. So, the federal government
increases its spending on infrastructure, resulting in increased hiring,
equipment purchases and profits in the infrastructure sector of the economy.
But with households cutting back on their current spending on goods and
services, that is, increasing their saving, spending and hiring in the
non-infrastructure sectors of the economy decline. There is <i style="mso-bidi-font-style: normal;">no net increase</i> in spending on
domestically-produced goods and services in the economy as a result of the
bond-financed increase in infrastructure spending. Rather, there is only a <i style="mso-bidi-font-style: normal;">redistribution</i> in total spending <i style="mso-bidi-font-style: normal;">toward</i> the infrastructure sector and <i style="mso-bidi-font-style: normal;">away</i> from other sectors.<o:p></o:p></div>
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What if a pension fund purchases the new bonds issued to
finance the increase in government infrastructure spending? Where does the
pension fund get the money to purchase the new bonds? One way might be from
increased pension contributions. But an increase in pension contributions
implies an increase in <i style="mso-bidi-font-style: normal;">saving</i> by the
pension beneficiary. The pension fund is just an intermediary between the
borrower, the government, and the ultimate saver, households or businesses
saving for the benefit of households. Again, there is <i style="mso-bidi-font-style: normal;">no net increase</i> in spending on domestically-produced goods and
services in the economy.<o:p></o:p></div>
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What if households or pension funds sell other assets to
nonbank entities to fund their purchases of new government bonds? Ultimately,
some nonbank entity needs to increase its saving to purchase the assets sold by
households and pension funds. Again, there is <i style="mso-bidi-font-style: normal;">no net increase</i> in spending on domestically-produced goods and
services in the economy.<o:p></o:p></div>
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What if foreign entities purchase the new government
bonds? Where do these foreign entities get the U.S. dollars to pay for the new
U.S. government bonds? By running a larger trade surplus with the U.S. That is,
foreign entities export more to the U.S. and/or import less from the U.S.,
thereby acquiring more U.S. dollars with which to purchase the new U.S.
government bonds.<span style="mso-spacerun: yes;"> </span>Hiring and profits
increase in the U.S. infrastructure sector, decrease in the U.S. export or
import-competing sectors. <o:p></o:p></div>
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<br /></div>
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Now, let’s assume that the new government bonds issued to
fund new government infrastructure spending are purchased by the depository
institution system (commercial banks, S&Ls and credit unions) and the
Federal Reserve. In this case, the funds to purchase the new government bonds
are created, figuratively, out of “thin air”. This implies that no other entity
need cut back on its current spending on goods and services while the
government increases it spending in the infrastructure sector. All else the
same, <b style="mso-bidi-font-weight: normal;">if an increase in government
infrastructure spending is funded by a net increase in thin-air credit, then
there will be a net increase in spending on domestically-produced goods and
services and a net increase in domestic employment.</b> We can<i style="mso-bidi-font-style: normal;">not</i> conclude that an increase in
government infrastructure spending funded from sources <i style="mso-bidi-font-style: normal;">other than thin-air credit</i> will unambiguously result in a net
increase in spending on domestically-produced goods and services and a net
increase in employment.<o:p></o:p></div>
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President-elect Trump’s economic advisers have suggested
that an increase in infrastructure spending could be funded largely by private
entities through some kind of public-private plan. This still would not result
in net increase in U.S. spending on domestically-produced goods and services
and net increase in employment <i style="mso-bidi-font-style: normal;">unless</i>
there were a net increase in thin-air credit. The private entities providing
the bulk of financing of the increased infrastructure spending would have to
get the funds either from some entities increasing their saving, that is, by
cutting back on their current spending, or by selling other existing assets
from their portfolios. As explained above, under these circumstances, there
would be no net increase in spending on domestically-produced goods and
services.<o:p></o:p></div>
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Now, it is conceivable that an increase in infrastructure
spending, while not resulting in an <i style="mso-bidi-font-style: normal;">immediate</i>
net increase in spending on domestically-produced goods and services, could
result in the economy’s <i style="mso-bidi-font-style: normal;">future potential</i>
rate of growth in the production of goods and services. To the degree that
increased infrastructure increases the productivity of labor, for example,
speeds up the delivery of goods and services, then that increase in
infrastructure spending could allow for faster growth in the <i style="mso-bidi-font-style: normal;">future</i> production of goods and services.
<o:p></o:p></div>
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<br /></div>
<div class="MsoNoSpacing">
Another key element in President-elect Trump’s proposed
policies to raise U.S GDP growth is to cut tax rates on households and
businesses.<span style="mso-spacerun: yes;"> </span>To the degree that tax-rate
cuts result in a redistribution of a given amount of spending away from pure
consumption to the accumulation of physical capital (machinery, <i style="mso-bidi-font-style: normal;">et. al.</i>), human capital (education) or
an increased supply of labor, tax-rate cuts might result in an increase in the <i style="mso-bidi-font-style: normal;">future</i> <i style="mso-bidi-font-style: normal;">potential</i> rate of growth in GDP, but <i style="mso-bidi-font-style: normal;">not</i> the immediate rate of growth<i style="mso-bidi-font-style: normal;">
unless</i> the tax-rate cuts are <i style="mso-bidi-font-style: normal;">financed
by a net increase in thin-air credit</i>. <o:p></o:p></div>
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<br /></div>
<div class="MsoNoSpacing">
At least starting with the federal personal income tax-rate
cut of 1964, all personal income tax-rate cuts have been followed with
cumulative net widenings in the federal budget deficits. So, for the sake of
argument, let’s assume that the likely forthcoming personal and business
tax-rate cuts result in a wider federal budget deficit. Suppose that households
in the aggregate use their extra after-tax income to purchase the new bonds the
federal government sells to finance the larger budget deficits resulting from
the tax-rate cuts. The upshot is that there is no net increase in spending on
domestically-produced goods and services nor is there any net increase in
employment emanating from the tax-rate cuts. <o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
My conclusion from the thought experiments discussed
above is that increases in federal government spending and/or cuts in tax rates
have no meaningful positive <i style="mso-bidi-font-style: normal;">cyclical</i>
effect on GDP growth <i style="mso-bidi-font-style: normal;">unless</i> the
resulting wider budget deficits are financed by a net increase in thin-air
credit, that is a net increase in the sum of credit created by the depository
institution system and credit created by the Fed.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Let’s look at some actual data relating changes in the
federal deficit/surplus to growth in nominal GDP. I have calculated the annual <i style="mso-bidi-font-style: normal;">calendar- year</i> federal
deficits/surpluses, and then calculated these deficits/surpluses as a percent
of annual average nominal GDP. The red bars in Chart 1 are the year-to-year
percentage-point changes in the annual budget deficits/surpluses as a percent
of annual-average nominal GDP. The blue line in Chart 1 is the year-to-year
percent change in average annual nominal GDP. According to mainstream Keynesian
theory, a widening in the budget deficit relative to GDP is a “stimulative”
fiscal policy and should be associated with faster nominal GDP growth. A
widening in the budget deficit relative to GDP would be represented by the red
bars in Chart 1 decreasing in magnitude, that is, becoming less positive or
more negative in value. <span style="mso-spacerun: yes;"> </span>According to
mainstream Keynesian theory, this should be associated with faster nominal GDP
growth, that is, with the blue line in Chart 1 moving up. Thus, according to
mainstream Keynesian theory, there should be a<i style="mso-bidi-font-style: normal;"> negative</i> correlation between changes in the relative budget
deficit/surplus and growth in nominal GDP. The annual data points in Chart 1
start in 1982 and conclude in 2007. This time span includes the Reagan
administration’s “stimulative” fiscal policies of tax-rate cuts and faster-growth
federal spending, the George H. W. Bush and Clinton administrations’
“restrictive” fiscal policies of tax-rate increases and slower-growth federal
spending and the George H. Bush administration’s “stimulative” fiscal policies
of tax-rate cuts and faster-growth federal spending.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<br /></div>
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<br /></div>
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<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 1<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-WM4kTsHFbYA/WDI3fk7GdJI/AAAAAAAAA9c/oI-GhoFF5WsaXVb7gVuXv_-vM9FUVXsaQCLcB/s1600/Deficits%2BStimulate%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="360" src="https://4.bp.blogspot.com/-WM4kTsHFbYA/WDI3fk7GdJI/AAAAAAAAA9c/oI-GhoFF5WsaXVb7gVuXv_-vM9FUVXsaQCLcB/s640/Deficits%2BStimulate%2BChart%2B1.png" width="640" /></a></div>
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<br /></div>
<div class="MsoNoSpacing">
In the top left-hand corner of Chart 1 is a little box
with “r=0.36” within it. This is the correlation coefficient between changes in
fiscal policy and growth in nominal GDP.<span style="mso-spacerun: yes;">
</span>If the two series are perfectly correlated, the <i style="mso-bidi-font-style: normal;">absolute</i> value of the correlation coefficient, “r”, would be equal
to 1.00. Both series would move in perfect tandem. As mentioned above,
according to mainstream Keynesian theory, there should be a <i style="mso-bidi-font-style: normal;">negative</i> correlation between changes in
fiscal policy and growth in nominal GDP. That is, as the red bars decrease in
magnitude, the blue line should rise in value. But the sign of the correlation
coefficient in Chart 1 is, in fact, <i style="mso-bidi-font-style: normal;">positive</i>,
<i style="mso-bidi-font-style: normal;">not</i> negative as Keynesians
hypothesize. Look, for example, at 1984, when nominal GDP growth (the blue
line) spiked up, but fiscal policy got “tighter”, that is the relative budget
deficit in 1984 got smaller compared to 1983. During the Clinton
administration, budget deficits relative to nominal GDP shrank every calendar
year from 1993 through 1997, turning into progressively higher <i style="mso-bidi-font-style: normal;">surpluses</i> relative to nominal GDP
starting in calendar year 1998 through 2000. Yet from 1993 through 2000,
year-to-year growth in nominal GDP was relatively steady holding in a range of
4.9% to 6.5%. Turning to the George H. Bush administration years, there was a
sharp “easing” in fiscal policy in calendar year 2002, with little response in
nominal GDP growth. As fiscal policy “tightened” in subsequent years, nominal
GDP growth picked up – exactly opposite from what mainstream Keynesian theory
would predict.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Of course, there are macroeconomic policies that might be
changing and having an effect on the cyclical behavior of the economy other
than fiscal policy. The most important of these other macroeconomic policies is
monetary policy, specifically the behavior of thin-air credit. In Chart 2, I
have added an additional series to those in Chart 1 – the year-to-year growth
in the annual average sum of depository institution credit and the monetary
base (reserves at the Fed plus currency in circulation). “Kasrielian” theory
hypothesizes that there should be a <i style="mso-bidi-font-style: normal;">positive</i>
correlation between changes in thin-air credit and changes in nominal GDP. With
three variables in chart, Haver Analytics will not calculate the cross
correlations among all the variables. But E-Views will. And the correlation
between annual growth in thin-air credit and nominal GDP from 1982 through 2007
is a <i style="mso-bidi-font-style: normal;">positive </i><span style="mso-spacerun: yes;"> </span>0.53. Not only is this correlation coefficient
1-1/2 times larger than that between changes in fiscal policy and nominal GDP
growth, more importantly, this correlation has the <i style="mso-bidi-font-style: normal;">theoretically correct </i>sign in front of it. By adding growth in
thin-air credit to the chart, we can see that the strength in nominal GDP
growth in President Reagan’s first term was more likely due to the Fed,
knowingly or unknowingly, allowing thin-air credit to grow rapidly. Similarly,
the reason nominal GDP growth recovered from the George H. W. Bush presidential
years and was relatively steady was <i style="mso-bidi-font-style: normal;">not</i>
because tax rates were increased in 1993 and federal spending growth slowed,
but rather because growth in thin-air credit recovered in 1994 and held
relatively steady through 1999.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 2<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://2.bp.blogspot.com/-dC688XmP99w/WDI3nuos0cI/AAAAAAAAA9g/X7lJ4C9fEC4R-oh-iYAyNLdaZUUlDKlFQCLcB/s1600/Deficits%2BStimulate%2BChart%2B2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="372" src="https://2.bp.blogspot.com/-dC688XmP99w/WDI3nuos0cI/AAAAAAAAA9g/X7lJ4C9fEC4R-oh-iYAyNLdaZUUlDKlFQCLcB/s640/Deficits%2BStimulate%2BChart%2B2.png" width="640" /></a></div>
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<span style="mso-no-proof: yes;"><!--[if gte vml 1]><v:shape id="Picture_x0020_4"
o:spid="_x0000_i1025" type="#_x0000_t75" style='width:468pt;height:273pt;
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<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div class="MsoNoSpacing">
In sum, there may be rational reasons why the U.S. equity
markets rallied in the wake of Donald Trump’s presidential election victory.
But an expectation of faster U.S. economic growth due to a more “stimulative”
fiscal policy is <i style="mso-bidi-font-style: normal;">not</i> one of them <i style="mso-bidi-font-style: normal;">unless</i> <i style="mso-bidi-font-style: normal;">the larger budget deficits are financed with thin-air credit. </i>Fed
Chairwoman Yellen, whether you know it or not, you are in the driver’s (hot?)
seat.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian, LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Co. of Neenah, WI</a> <o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.the-econtrarian.blogspot.com/">The
Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
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<div class="MsoNoSpacing">
“For most of human history, it has made good adaptive
sense to be fearful and emphasize the negative; any mistake could be fatal”,
Joost Swarte<o:p></o:p></div>
Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com4tag:blogger.com,1999:blog-3399546775946309435.post-70443132970991378332016-11-01T09:33:00.001-07:002016-11-01T09:33:13.099-07:00The Fed Began Tightening Policy in October and No One Knew It, Maybe Not Even the Fed<div align="right" class="MsoNoSpacing" style="text-align: right;">
November 1, 2016<o:p></o:p></div>
<div align="right" class="MsoNoSpacing" style="text-align: right;">
<br /></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<b style="mso-bidi-font-weight: normal;"><u>The Fed Began Tightening Policy in
October and No One Knew It, Maybe Not Even the Fed<o:p></o:p></u></b></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div class="MsoNoSpacing">
I am so old that I can remember when the Fed tightened
policy without any public announcements, often between FOMC meetings. Sometimes
it took several days after the Fed implemented the tightening for a consensus
to develop among Fed-watchers that a tightening had, in fact, taken place. But,
at least, the Fed knew immediately when it had implemented a tightening. I
believe that the Fed commenced a stealth tightening of monetary policy in
October. But one possible difference between this current tightening and the
tightenings of yesteryear is that it is not clear that even the Fed realizes
that a tightening has occurred of late.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
The reason I believe that the Fed has tightened monetary
policy is because of the deceleration in the growth of thin-air credit, that
is, a deceleration in the growth of credit created by the Fed and the commercial
banking system. One element of the Fed’s contribution to thin-air credit is the
reserves created for the depository institution system. These reserves are held
at the Fed. The other component of thin-air credit created by the Fed is the
currency held by depository institutions in their vaults and the currency held
by the nonbank public. Depository institution reserves held at the Fed and
currency is often referred to as the monetary base. Depository institutions are
commercial banks, S&Ls and credit unions. Commercial banks account for over
90% of the total assets of depository institutions. Depository institutions
create thin-air credit by granting loans and purchasing securities. Plotted in
Chart 1 are the 52-week annualized percent changes in the sum of commercial
bank credit plus the monetary base from November 4, 2015 through October 19,
2016. From January 1960 through September 2016, the median year-over-year
growth in this thin-air credit aggregate was 7.1%. From November 4, 2015
through October 19, 2016, the median 52-week annualized growth in this thin-air
credit aggregate was 4.4%.<b style="mso-bidi-font-weight: normal;"> In the 52
weeks ended October 19, 2016, the annualized growth in this thin-air credit was
2.8%. </b>Annualized growth in total thin-air credit of 4.4% is weak in an
historical context. 2.8% annualized growth is <i style="mso-bidi-font-style: normal;">very </i>weak.<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 1<o:p></o:p></div>
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<div align="center" class="MsoNoSpacing" style="text-align: center;">
<div class="separator" style="clear: both; text-align: center;">
<a href="https://1.bp.blogspot.com/-RzbK2iP-NPg/WBjCQyTEC2I/AAAAAAAAA8s/3I55IpRdFgYg-sxwctgnNF-FRZLQVZbOgCLcB/s1600/Fed%2BBegan%2BTightening%2BChart%2B1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="330" src="https://1.bp.blogspot.com/-RzbK2iP-NPg/WBjCQyTEC2I/AAAAAAAAA8s/3I55IpRdFgYg-sxwctgnNF-FRZLQVZbOgCLcB/s640/Fed%2BBegan%2BTightening%2BChart%2B1.png" width="640" /></a></div>
<br /></div>
<div class="MsoNoSpacing">
<div class="separator" style="clear: both; text-align: center;">
</div>
Commercial banks are doing their part to create thin-air
credit. Chart 2 shows the 52-week annualized growth in commercial bank credit
from November 4, 2015 through October 19, 2016. From January 1960 through
September 2016, the median year-over-year growth in commercial bank credit was
7.4%. In the 52-weeks ended October 19, 2016, the annualized growth in
commercial bank credit was 7.9%. So, banks have been cranking out thin-air
credit at a robust pace. Therefore, it must have been a recent sharp slowdown
in the growth of the monetary base that caused the relatively sharp
deceleration in the growth of total thin-air credit.<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 2<o:p></o:p><br />
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<a href="https://3.bp.blogspot.com/-58EPPWJpMnw/WBjCqPceIiI/AAAAAAAAA8w/HFp0YXbhTCMHs-jgvuXZyRvJm2rhdzYggCLcB/s1600/Fed%2BBegan%2BTightening%2BChart%2B2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="270" src="https://3.bp.blogspot.com/-58EPPWJpMnw/WBjCqPceIiI/AAAAAAAAA8w/HFp0YXbhTCMHs-jgvuXZyRvJm2rhdzYggCLcB/s640/Fed%2BBegan%2BTightening%2BChart%2B2.png" width="640" /></a></div>
<br /></div>
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<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
Plotted in Chart 3 are the Wednesday weekly dollar levels
of the monetary base from November 4, 2015 through October 26, 2016. You will
notice two distinct plunges in the level of the monetary base. The first
distinct plunge started in December 2015. This was when the Fed hiked its
target federal funds rate level by 25 basis points. In order to get the federal
funds rate to rise toward the Fed’s desired higher level, the Fed needed to
reduce the supply of reserves available to depository institutions relative
depository institutions’ demand for reserves. But why has the level of the
monetary base plunged starting in late September 2016? The Fed did <i style="mso-bidi-font-style: normal;">not</i> raise its <i style="mso-bidi-font-style: normal;">target </i>federal funds rate level at the September 2016 FOMC meeting
(although overnight bank funding costs have crept higher).<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 3<o:p></o:p><br />
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<a href="https://4.bp.blogspot.com/-bTO-e49JBLM/WBjDNh2j5_I/AAAAAAAAA80/NP6eWa07kjw8B7iY8RqrzECAGUGoEHaEACLcB/s1600/Fed%2BBegan%2BTightening%2BChart%2B3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="266" src="https://4.bp.blogspot.com/-bTO-e49JBLM/WBjDNh2j5_I/AAAAAAAAA80/NP6eWa07kjw8B7iY8RqrzECAGUGoEHaEACLcB/s640/Fed%2BBegan%2BTightening%2BChart%2B3.png" width="640" /></a></div>
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<div class="MsoNoSpacing">
The net dollar change in the monetary base, consisting of
liability items on the Fed’s balance sheet, in the six weeks ended October 26,
2016 was a decline of $277 billion. The net dollar change in Fed assets,
largely securities owned by the Fed and discount window loans to depository
institutions, during this period was a decline of $27 billion. So, the bulk of
the $277 billion decrease in the monetary base must have been due to some other
Fed liability items that absorb, or drain, funds from the financial system. One
of those liability items that comes to mind is Fed reverse repurchase
agreements with money funds and primary government securities dealers. When a
money fund enters into a reverse repo with the Fed, the money fund, in effect,
makes a short-term loan to the Fed, receiving as collateral for that loan some
Treasury securities that the Fed has in its portfolio. A Fed reverse repo
drains reserves, one of the components of the monetary base, from the
depository institution system.<span style="mso-spacerun: yes;"> </span>To the
money fund, entering into a reverse repo is a substitute for purchasing a
Treasury bill. Both are short-term and both are guaranteed by the federal
government. Chart 4 shows the behavior of Fed reverse repurchase agreements
with money funds and primary government securities dealers from November 4,
2015 through October 26, 2016. Fed reverse repos shot up in late December 2015,
presumably to reduce depository institution reserves in order to push up the
federal funds rate to its higher desired level. But why did Fed reverse repos
spike up in late September and early October of 2016?<o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
Chart 4<o:p></o:p><br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://3.bp.blogspot.com/-kL9uhGm9vp8/WBjDdr5N1MI/AAAAAAAAA84/j7oJXLgk-oIa7ZX8txEjNh4Plgc3GotigCLcB/s1600/Fed%2BBegan%2BTightening%2BChart%2B4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="272" src="https://3.bp.blogspot.com/-kL9uhGm9vp8/WBjDdr5N1MI/AAAAAAAAA84/j7oJXLgk-oIa7ZX8txEjNh4Plgc3GotigCLcB/s640/Fed%2BBegan%2BTightening%2BChart%2B4.png" width="640" /></a></div>
<br /></div>
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<div align="center" class="MsoNoSpacing" style="text-align: center;">
<br /></div>
<div class="MsoNoSpacing">
The recent spike in Fed reverse repurchase agreements
with money funds and primary government securities dealers might be related to
a change in money fund regulations that went into effect in mid-October 2016. On
July 23, 2014, the Securities and Exchange Commission amended <a href="https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542347679">Rule
2A-7</a> of the Investment Company Act of 1940. Rule 2A-7 pertains to the
regulation of money market mutual funds. Among other things, the amendments to
Rule 2A-7 require institutional prime and institutional municipal money funds
to float their daily net asset values. That is, a prime money fund must
mark-to-market the value of its assets daily rather than automatically valuing
each share at $1.00. Money funds marketed to individual household investors,
retail money funds, are allowed to continue valuing a share at $1.00. An
institutional prime money fund invests primarily in <i style="mso-bidi-font-style: normal;">non</i>-government guaranteed short-term fixed-income securities such
as commercial paper and large negotiable bank-issued certificates of deposit.
The amendments to Rule 2A-7 allow institutional money funds that invest in
government-guaranteed assets to continue valuing a share at $1.00. As
mentioned, these amendments to Rule 2A-7 went into effect in mid-October 2016. <o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
According to Investment Company Institute data, in the 52
weeks ended October 26, 2016, the total assets of institutional prime money
funds <i style="mso-bidi-font-style: normal;">declined</i> by $774 billion. In
this same time period, the total assets of institutional government money funds
increased<i style="mso-bidi-font-style: normal;"> </i>by $763 billion. One likely
motivating factor for this shift <i style="mso-bidi-font-style: normal;">out of </i>prime
money funds and <i style="mso-bidi-font-style: normal;">into</i> government money
funds by institutional investors is the amended Rule 2A-7. Whatever the
motivation for this shift in portfolio preference by institutional investors,
the result has been an increase in <i style="mso-bidi-font-style: normal;">demand
</i>for short-maturity government-guaranteed fixed-income securities. One
important component of the <i style="mso-bidi-font-style: normal;">supply</i> of
short-maturity government-guaranteed fixed-income securities, U.S. Treasury
bills, has not kept pace with the increased demand. In the 12 months ended
September 2016, the amount of Treasury bills outstanding increased by only $289
billion. But there is another source of supply of government-guaranteed
short-maturity fixed-income securities available to money funds – reverse
repurchase agreements with the Federal Reserve. <o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
<b style="mso-bidi-font-weight: normal;">It is conceivable,
then, that the money fund reforms incorporated in the amendments to SEC Rule
2A-7 might have inadvertently contributed to the recent Fed tightening of
monetary policy by inducing money funds to step up their use of Fed reverse
repurchase agreements, which drain reserves from the financial system. </b>Of
course, the Fed could have offset the drain in reserves resulting from the
increased volume of reverse repos by injecting additional funds into the
financial system through the Fed’s purchase of securities in the open market.
But the Fed has not done this. <o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
As mentioned above, in the six weeks ended October 26,
2016, the monetary base contracted a net $277 billion. During this same period,
the increase in Fed reverse repurchase agreements with money funds and primary
dealers accounted for a net $78 billion of the $277 billion decline in the
monetary base. So, there must have been some other factor on the liability side
of the Fed’s balance sheet that was contributing to the contraction in the
monetary base. That factor is U.S. Treasury deposits at the Fed. When the
Treasury receives revenues from tax payments and/or security sales, these receipts
often first appear in the Treasury’s deposit account at the Fed. For example,
when I pay my taxes, my checking account balance decreases by $X, my bank’s
reserves at the Fed decrease by $X and the Treasury’s deposit account at the
Fed increases by $X. Reserves have, thus, been drained from the financial
system. If the Treasury is not immediately going to spend these additional
funds, it often redeposits a part of its increased balances at the Fed with
private depository institutions. This restores part of reserves that were
previously drained from the financial system when the tax or securities payment
were first deposited in the Fed’s account at the Fed.<span style="mso-spacerun: yes;"> </span>But to the degree that Treasury deposit
balances at the Fed increase, reserves are drained from the financial system by
that amount, all else the same. <o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
For reasons not known to me, both the Treasury’s overall
cash balance and its balance at the Fed have been increasing significantly
starting in 2015. In the six weeks ended October 26, 2016, the Treasury’s deposit
balance at the Fed increased a net $168 billion. The Fed could have injected
reserves into the financial system through securities purchases to offset this
$168 billion reserves drain from higher Treasury balances, but it didn’t. Rather,
as mentioned above, the Fed let its assets <i style="mso-bidi-font-style: normal;">decline</i>
a net $27 billion during this six-week period.<o:p></o:p></div>
<div class="MsoNoSpacing">
<br /></div>
<div class="MsoNoSpacing">
In the old days, before Fed policy change announcements,
Fed-watchers, observing the monetary base declining and bank overnight funding
interest rates rising (see Chart 5), likely would have concluded that the Fed
had tightened monetary policy. But to the best of my knowledge, no one,
including the Fed, has indicated as such. But in terms of the deceleration in
the growth of thin-air credit and the drift up in overnight bank funding
interest rates, the Fed <i style="mso-bidi-font-style: normal;">has </i>tightened
monetary policy in recent weeks. What’s more, assuming that the October 2016
employment report, to be released Friday, November 4, is not a washout, the Fed
is likely to formally tighten again at the conclusion of its December 13-14,
2016 FOMC meeting by announcing a 25 basis point increase in its target level
for the federal funds rate. This will imply that the Fed will have to reduce
the monetary base even more in order to push the federal funds rate up toward
its new desired higher level. In turn, this will imply a further deceleration in
the growth of thin-air credit from an already anemic current 52-week growth
rate of 2.8%. <b style="mso-bidi-font-weight: normal;">Investors, get ready for
slower U.S. economic growth in the first half of 2017. And Fed, get ready for a
barrage of criticism from the administration of the next President, whoever it
is.</b><o:p></o:p></div>
<div align="center" class="MsoNoSpacing" style="text-align: center;">
<a href="https://www.blogger.com/blogger.g?blogID=3399546775946309435" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"></a><a href="https://www.blogger.com/blogger.g?blogID=3399546775946309435" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"></a>Chart 5<o:p></o:p><br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://www.blogger.com/blogger.g?blogID=3399546775946309435" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"></a><a href="https://www.blogger.com/blogger.g?blogID=3399546775946309435" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"></a><a href="https://www.blogger.com/blogger.g?blogID=3399546775946309435" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"></a><a href="https://4.bp.blogspot.com/-JT6hn95ssrU/WBjDpLnEceI/AAAAAAAAA88/jTT-aalJqZQi7s5X3SHNuUd8l98VEdpLQCLcB/s1600/Fed%2BBegan%2BTightenig%2BChart%2B5.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="300" src="https://4.bp.blogspot.com/-JT6hn95ssrU/WBjDpLnEceI/AAAAAAAAA88/jTT-aalJqZQi7s5X3SHNuUd8l98VEdpLQCLcB/s640/Fed%2BBegan%2BTightenig%2BChart%2B5.png" width="640" /></a></div>
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<span style="mso-no-proof: yes;"><!--[if gte vml 1]><v:shape id="Picture_x0020_5"
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<br /></div>
<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
<div class="MsoNoSpacing">
Founder, Econtrarian, LLC<o:p></o:p></div>
<div class="MsoNoSpacing">
Senior Economic and Investment Advisor<o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="http://www.lptrust.com/">Legacy Private Trust
Company, Neenah, Wisconsin</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="https://www.blogger.com/the-econtrarian.blogspot.com">The Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
<a href="mailto:econtrarian@gmail.com">econtrarian@gmail.com</a><o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
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<br /></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com3tag:blogger.com,1999:blog-3399546775946309435.post-87654276669560431752016-10-02T14:29:00.000-07:002016-10-02T14:29:30.793-07:00The Imposition of Import Restrictions Is a Recipe for a Declining Standard of Living<div align="right" class="MsoNoSpacing" style="text-align: right;">
October 3, 2016<o:p></o:p></div>
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<b style="mso-bidi-font-weight: normal;"><u>The Imposition of Import Restrictions Is
a Recipe for a Declining Standard of Living<o:p></o:p></u></b></div>
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Both 2016 U.S. presidential candidates of the two major
political parties are, to greater and lesser degrees, advocating the imposition
of restrictions on U.S. imports if foreign exporters engage in “unfair” trade
practices. Regardless of whether foreign exporters engage in perceived unfair
trade practices, I believe that the imposition of restrictions on U.S. imports
would result in a decline in the standard of living of Americans in the
aggregate.<o:p></o:p></div>
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The benefit to an economy from trade is imports, <i style="mso-bidi-font-style: normal;">not</i> exports. When U.S. workers produce
goods and services that are exported, neither those U.S. workers nor other U.S.
residents get to consume those exported goods and services. Rather, the foreign
recipients, the importers of these goods and services, consume them. Exports
are what we have to give up in order to obtain imports. The fewer exports we
have to give up to obtain a given amount of imports, the better off we are.<o:p></o:p></div>
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Let’s run a little thought experiment. Suppose that the
Chinese government, embracing the mercantilism that Adam Smith excoriated way
back in 1776, provided Haier Group, a Chinese-based home appliance
manufacturer, a subsidy such that enabled Haier to offer refrigerators for sale
in U.S. for $1 each. Should the U.S jump on this deal of $1 dollar
refrigerators or impose a tariff on Haier refrigerators so that their U.S.
price was closer to those of Whirlpool and Frigidaire refrigerators? If you were
a worker at or a stockholder of U.S. Whirlpool and Frigidaire, you would lobby
for the tariff on Haier refrigerators. But those of us who do not earn income
from Whirlpool or Frigidaire would most likely opt for the $1 Haier
refrigerators. <o:p></o:p></div>
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If we allowed imported Haier refrigerators to be sold in
the U.S. for $1 each, would workers and stockholders associated with Whirlpool,
Frigidaire and their suppliers be economically harmed? Yes, initially. Would
U.S. residents, <i style="mso-bidi-font-style: normal;">in the aggregate</i>,
benefit from the imported $1 Haier refrigerators? Yep. We could purchase more
refrigerators and still have a lot of income left over to purchase other goods
and services. Our increased demand for other goods and services would result in
additional hiring, production and profits in industries not directly related to
Whirlpool and Frigidaire. Some of those<span style="mso-spacerun: yes;">
</span><span style="mso-spacerun: yes;"> </span>laid- off Whirlpool and
Frigidaire workers would find employment in those industries experiencing
increased demand as a result of the lower-cost imported refrigerators. As a
result of the Chinese government’s subsidy to Haier, we in the U.S. would be
able to consume <i style="mso-bidi-font-style: normal;">more</i> refrigerators
and <i style="mso-bidi-font-style: normal;">more</i> of other goods and services
at a lower general price level, all else the same. That is, <i style="mso-bidi-font-style: normal;">in the aggregate, </i>the American standard
of living would rise.<o:p></o:p></div>
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I can hear you now. This is typical ivory-tower analysis.
In the real world, a lot of those laid-off would not be able to get re-employed
in other industries quickly or at a comparable wage rate because of inadequate
skills or geographical-mobility issues. Let’s assume that this is the case for <i style="mso-bidi-font-style: normal;">all </i>laid-off workers in industries
related to the domestic production of refrigerators. Let’s also assume that
there are many more families that purchase refrigerators than there are
families involved in the domestic production of refrigerators. Under these
circumstances, the U.S. government could impose a tariff on imported Haier
refrigerators at a level such that the revenues from this tariff could be
transferred to the displaced workers, leaving them monetarily no worse off
while leaving everyone else better off. <span style="mso-spacerun: yes;"> </span>This
tariff would result in the price of U.S. refrigerators being higher than $1 but
less than what the price was before the Chinese government started subsidizing
Haier.<o:p></o:p></div>
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Who are the real losers in the $1 Haier refrigerator
deal? Chinese taxpayers. They end up subsidizing U.S. consumers of
Chinese-produced refrigerators. Moreover, China will be using more of its resources
to produce refrigerators for <i style="mso-bidi-font-style: normal;">U.S
consumption</i>. This leaves fewer Chinese resources to produce other goods and
services for Chinese residents to consume. In effect, the Chinese taxpayers
would be providing “foreign aid” to U.S residents. How do you say “thank you”
in Mandarin?<o:p></o:p></div>
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Okay. Let’s come down from the ivory tower to the real
world. In September 2009, President Obama imposed additional tariffs on
imported Chinese tires of 35%, 30% and 25% in years one, two and three,
respectively. The President was responding to a finding by the U.S.
International Trade Commission (ITC) that imported Chinese tires were causing
“market disruption” to the U.S. domestic production of tires. A labor union
representing U.S. tire workers requested the inquiry by the ITC. A<a href="https://piie.com/publications/policy-briefs/us-tire-tariffs-saving-few-jobs-high-cost">
study</a> by the nonpartisan Peterson Institute for International Economics
(PIIE) found that the total cost of these new tire tariffs on Chinese tires
resulted in higher tire costs to U.S. consumers of around $1.1 billion in 2011.
The PIIE study estimated that a maximum of 1,200 jobs were “saved” in the U.S.
tire-production industry by these additional tariffs. Thus, the cost to U.S.
consumers <i style="mso-bidi-font-style: normal;">per </i>U.S. tire-production <i style="mso-bidi-font-style: normal;">job saved</i> was around $900 thousand in
2011. Furthermore, the PIIE study estimated that because of the increased cost
of tires to U.S. consumers, these consumers had to reduce expenditures on other
goods and services, which resulted in the loss of 3,731 other jobs in the
retail sector. So, the price of tires increased to American consumers and they
had to cut back on their consumption of other goods and services – a drop in
the American standard of living by any other name.<o:p></o:p></div>
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The $1.1 billion of additional tire costs on American
consumers via a higher tariff on imported Chinese tires in 2011 works out to
$13.27 per U.S. family in that year – not an exorbitant<span style="mso-spacerun: yes;"> </span>amount. But, instead of imposing the tire
tariff, if the U.S. government had increased taxes on every U.S. family of 64 <i style="mso-bidi-font-style: normal;">cents</i> and transferred those additional
tax revenues to the 1,200 domestic tire-production workers who would have lost
their jobs without the higher tariff, the laid-off tire-production workers
would have been no worse off monetarily in 2011 and everyone else would have
been better off than with the tariff. <o:p></o:p></div>
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Why didn’t those citizens not employed in the
tire-production industry write President Obama and/or their federal legislators
to protest the imposition of the higher tariff on imported Chinese tires?
Because $13.27 more annually per family due to higher tire tariffs was only
0.02% of the 2011 median family income --small potatoes. Why didn’t the 3,731
retail workers who lost their jobs because of the higher tire tariffs protest?
Because they probably could not connect the dots between the increase in the
tire tariffs and the decline in other retail sales. But those in the U.S.
tire-production industry could clearly see that less expensive Chinese tire
imports were adversely affecting their livelihoods and they had lobbyists and
union leaders who were going to squawk about it.<o:p></o:p></div>
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Whether foreign governments conduct fair or unfair trade
practices, there will be certain U.S. industries harmed economically as imports
increase. But there will be more U.S. residents who benefit economically from
these increased imports than will be harmed. If our federal legislators took
into consideration the economic well-being of Americans <i style="mso-bidi-font-style: normal;">in the aggregate</i>, they could devise a system to compensate those
harmed by the increased imports so as to leave them no worse off. Extra taxes
or tariffs would be needed to fund this compensation. But these extra
taxes/tariffs would be low enough to leave those who benefitted from increased
imports better off than before. Because the “losers” from increased imports are
easier to identify than the more diffuse “winners”, it is politically more
expedient to argue in favor of import restrictions than a more rational
compensation program that would leave the “losers” from imports no worse off
economically and everyone else better off.<o:p></o:p></div>
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In sum, if the trade-restriction rhetoric being voiced by
the presidential candidates of both major political parties turns into actual
trade restrictions after the election, the standard of living of Americans in
the aggregate will be adversely affected. We will end up with slower growth in
goods and services available for us to consume and a higher rate of consumer
inflation. Adam Smith must be spinning in his grave.<o:p></o:p></div>
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<div class="MsoNoSpacing">
Paul L. Kasriel<o:p></o:p></div>
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Founder, Econtrarian, LLC<o:p></o:p></div>
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Senior Economic and Investment Advisor<o:p></o:p></div>
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<a href="http://www.lptrust.com/">Legacy Private Trust
Co. of Neenah, Wisconsin</a><span class="MsoHyperlink"><o:p></o:p></span></div>
<div class="MsoNoSpacing">
<a href="https://www.blogger.com/Downloads/the-econtrarian.blogspot.com">The
Econtrarian</a><o:p></o:p></div>
<div class="MsoNoSpacing">
econtrarian@gmail.com<o:p></o:p></div>
<div class="MsoNoSpacing">
1-920-818-0236<o:p></o:p></div>
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Paul Kasrielhttp://www.blogger.com/profile/03284214951073377347noreply@blogger.com4