September 23, 2013
Even
with No Fed Taper, Look for Slower
Growth in Nominal Transactions
The
Fed decided on September 18 to maintain its rate of securities purchases at $85
billion per month rather than reducing or “tapering” the amount of its monthly
securities purchases as was, for reasons not entirely clear to me, was widely
expected by the financial market cognoscenti.
Many analysts interpreted the Fed’s decision not to taper as one of maintaining
the same degree of monetary policy accommodation. As Milton Friedman used to
teach, the degree of accommodation or restriction of monetary policy cannot be
evaluated in isolation, but rather
must be evaluated in relation to the
actions of the banking system. For example, in the early 1930s, Federal Reserve
credit grew quite rapidly. In isolation, this appeared to be a very
accommodative monetary policy. However, given that banks were contracting their
credit by amounts greater than the amounts of credit being created by the Fed,
monetary policy turned out to be very restrictive, relatively speaking. Similarly,
this econtrarian would argue that the Fed’s decision to maintain its securities
purchase program at $85 billion per month will result in a tightening in monetary policy if recent trends in the behavior of commercial bank credit persist. This
tightening in monetary policy is likely to result in slower growth in nominal
transactions. That is, we should expect to see slower growth in the nominal
domestic demand for goods and services and/or a slower rate of increase in the
prices of risk assets such as equities. Mind you, had the Fed decided on
September 18 to taper the rate at which it was going to purchase securities,
this would have resulted in an even greater tightening in monetary policy than
the no-taper decision did.
As
shown in the chart below, in three of the four months ended August, commercial
bank credit – loans and securities on the books of commercial banks – contracted. Because interest rates rose
sharply during this period, banks would have experienced unrealized losses on
their securities holdings. In accounting for the level of securities holdings
of commercial banks in its H.8 release, the Fed adjusts the value of these
bank-held securities by their unrealized gains or losses. Because of the
interest rate increases in the four months ended August 2013, these unrealized
losses would have exaggerated the decline in bank credit. In order to compensate
for these unrealized securities losses, I have adjusted commercial bank
securities holdings by a memo item in the H.8 report, “unrealized gains
(losses) on available-for-sale securities”. To emphasize that recent weakness
in total commercial bank credit is not due solely
to declines in securities holdings, the chart also contains the
month-to-month behavior of commercial bank loans and leases. In two of the past
four months ended August, commercial bank loans and leases have contracted.
As
I have argued ad nauseam in previous
commentaries, both Federal Reserve credit and commercial bank credit are credit
that is created figuratively out of thin air. A net increase in thin-air credit
is likely to result in a net increase in nominal transactions in an economy
because no other entity in the economy need cut back on its current
transactions as the recipients of this new thin-air credit increase their
transactions. If commercial banks began restricting their thin-air credit
creation, perhaps because of capital constraints, then, all else the same, the
growth in nominal transactions in the economy would slow. But, if the Federal
Reserve did not desire a slowdown in the growth of nominal transactions, it
could step up its thin-air credit creation to compensate for the shortfall in
commercial bank credit creation. According to this view, then, a view to which
I subscribe (and apparently only I),
whether monetary policy is becoming more accommodative (more restrictive)
depends on whether the sum of Fed
credit and commercial bank credit is
growing faster (slower).
In
mid-September 2012, the Fed embarked on its third round of securities
purchases, QEIII. In the 11 months ended August 2013, the 11 months in which
QEIII has been in effect, the Fed’s balance sheet, i.e., total factors
supplying reserve funds (Federal Reserve release H.4.1) had increased by $76.4
billion per month on average. (In these same 11 months, Fed outright holdings
of Treasury coupon and mortgage-backed securities increased $74.0 billion per
month on average.) In the 12 months ended September 2012, the sum of Fed credit and commercial bank credit had increased 4.1%. In the 11 months
ended August 2013, the time period for which QEIII has been in effect, the sum of Fed credit and commercial bank credit had increased at an annualized rate of 9.2%.
To put these percentage changes in perspective, the median year-over-year
change in the sum of Fed credit and commercial bank credit starting in
March 1990 has been 6.7%. So, in the 12 months prior to the commencement of
QEIII, this credit sum had grown 260 basis points below its longer-run median and at the end of 11 months of QEIII,
this credit sum had grown 250 basis
points above its longer-run median.
If,
over the next 12 months, the Fed’s balance sheet continues to increase by $76.4
billion per month and total
commercial bank credit remains static
at its August level, then, in the 12 months ended August 2014, the sum of Fed credit and commercial bank credit will have increased by 6.7%. This
represents a 250 basis point deceleration
in growth from what it had been in the 11 months ended August 2013. If total
commercial bank credit over the 12 months ended August 2014 contracts by 0.8%, its annualized rate
of contraction in the four months
ended August 2013, and Fed credit increases by $76.4 billion per month, then in
the 12 months ended August 2014 the sum
of Fed credit and bank credit will
have increased by 6.1%. This represents a 310 basis point deceleration in growth from what it had been in the 11 months ended
August 2013.
Now,
annualized growth in the sum of Fed
credit and commercial bank credit in
the range of 6.1% to 6.7% in the context of a longer-run median growth rate of
6.7% for this credit aggregate does not represent a restrictive monetary policy
in an absolute sense. But, as
discussed above, if this credit aggregate does, in fact, grow in this range
over the next 12 months, it would represent a move toward more restriction or
less accommodation, however you want to describe it, than what prevailed in the
11 months ended August 2013. And, as it would be more restrictive/less
accommodative, then we should expect a moderation in the growth of nominal
transactions over the coming 12 months, which would imply a moderation in the
rate of advance in equity prices.
I
have to admit that I am puzzled by the recent contraction in commercial bank credit.
The most recent Fed survey of bank lending terms showed an easing in those
terms, which would imply faster growth in bank credit, not a contraction.
Although recent unrealized losses on bank holdings of securities due to rising
interest rates might have reduced bank capital, in general, bank capital ratios
are higher than required. So, it is entirely possible that bank credit could
start to grow again in the near future. But, in the other direction, we could
be just one random number, i.e., one employment report, away from a Fed
decision to reduce its rate of securities purchases, according to comments made
by St. Louis Fed President Bullard on September 20. The upshot of all this is
that if you want to know where the economy is headed, “follow the money’, more accurately, follow the thin-air
credit, by keeping an eye on the Fed’s H.4.1 report, Factors Affecting Reserve
Balances, released on Thursday afternoons and the Fed’s H.8 report, Assets and
Liabilities of Commercial Banks in the U.S., released on Friday afternoons.
Paul
L. Kasriel
Econtrarian,
LLC
Senior
Economic and Investment Adviser
Legacy
Private Trust Co. of Neenah, WI
1-920-818-0236
