July 14, 2015
If the Fed Raises Policy Interest Rates
in 2015, It’s Likely to Be One and Done
Last week, Fed Chairperson Yellen indicated that the Fed
was likely to raise its policy interest rates sometime before year end. Given
the behavior of the sum of commercial bank credit and depository institution
reserves at the Fed in the past three quarters, it is a mystery to me why the
Fed would be contemplating a policy interest rate increase at this juncture.
But if this is something the Fed just has to get out of its system, then the first
increase is unlikely to be followed by a second interest rate increase for some
time.
To briefly review my focus on the sum of commercial bank
credit and reserves at the Fed , because depository institutions (commercial
banks, savings institutions and credit unions) are required to hold only a
fraction of the amount of their deposits as reserves at the Fed, they are able
to create credit by an amount that is a multiple of their reserves. This credit
is figuratively created out of thin air. The reserves that depository
institutions hold at the Fed are, in fact, created by the Fed. When an asset
item on the Fed’s balance sheet increases, say a Fed purchase of securities, a
liability item on the Fed’s balance sheet also increases. One liability item on
the Fed’s balance sheet is reserves owed to depository institutions. So, these
reserves, which serve as the “seed money” for the credit created by depository
institutions, also are figuratively created out of thin air.
Entities typically borrow in order to purchase something
– a good, a service, a financial instrument. When the credit that is financing
purchases is created out of thin air, net spending in the economy increases as
the borrowers increase their spending and no one else cuts back on his/her
spending. In contrast, when the credit that is financing purchases emanates
from new saving, then the change in net spending in the economy is zero. Saving
is the act of curbing one’s current spending and transferring this purchasing
power to a borrower. So, the borrower increases his/her current spending and
the saver decreases his/her current spending.
Plotted in Chart 1 are the year-to-year percent changes
in the sum of depository institution credit and reserves held at the Fed along
with the year-to-year percent changes in nominal Gross Domestic Purchases.
Gross Domestic Purchases are expenditures by U.S. households, businesses and
government entities on newly-produced goods and services. So, expenditures on
imported goods and services are included in Gross Domestic Purchases while
expenditures by foreign entities on U.S.-produced exports of goods and services
are excluded. From 1953 through 2014, the contemporaneous correlation between
percent changes in thin-air credit and percent changes in Gross Domestic
Purchases is 0.59 out of a maximum possible 1.00. Gross Domestic Purchases does
not include the value of used
products purchased (e.g., used cars and existing homes) and does not include
the value of financial instruments purchased. If a measure existed that added
these excluded items to Gross Domestic Purchases, it is likely that the
correlation between its changes and changes in thin-air credit would be even
higher than 0.59.
Chart 1
So, now you know why I am obsessed with thin-air credit
with respect to monetary policy. The behavior of thin-air credit plays an
important role in behavior of nominal spending in the economy. If the growth in
thin-air credit is rapid, the risk of the economy overheating and/or the
formation of asset-price bubbles would be heightened. If growth in thin-air
credit were rapid, increases in Fed policy interest rates would be entirely
appropriate in order to prevent a rise in the inflation rate of goods/services
and/or asset prices.
But, as shown in Chart 2, growth in a subset of total
thin-air credit, the sum of commercial bank credit and reserves at the Fed, has
been decelerating in recent quarters and is below its long-run median growth
rate. Chart 2 contains growth rates in the sum of commercial bank credit and
reserves at the Fed. Commercial bank credit accounts for over 80% of total
depository institution credit. The Fed reports commercial bank credit weekly
with a one-week lag, whereas it reports total depository institution credit
only quarterly with about a one-quarter lag. The long-run median growth rate in
the sum of commercial bank credit and reserves at the Fed is 7.1%. As shown in
Chart 2, growth in the sum of commercial bank credit and reserves at the Fed
was 6.0% in Q2:2015 vs. Q2:2014. Moreover, the growth in the sum of commercial
bank credit and reserves at the Fed has been trending decidedly slower starting
in Q4:2014, when the Fed terminated its QE program. Quarter-to-quarter
annualized growth in the sum of commercial bank credit and reserves at the Fed
slipped to 5.1% in Q2:2015 and its trend growth has been decelerating since
Q4:2013. This current below “normal” growth in the largest component of
thin-air credit implies that the dangers of a near-term overheated economic
environment and/or inflation of an asset-price bubble are low.
Chart 2
The principal factor accounting for the recent slowing in
the growth of thin-air credit is the Fed’s contribution, reserves at the Fed.
This is shown in Chart 3, in which 3-month point-to-point annualized growth
rates are plotted instead of growth rates of quarterly averages. Starting in
November 2014, the month after the Fed’s QE program ended, the three-month
annualized percent changes in reserves at the Fed, with two exceptions, have
been in negative territory. That is, since the end of QE, reserves at the Fed
have contracted on net. But the bank-credit component of thin-air credit also
has demonstrated a slowing growth trend. After surging in the three months
ended January 2015 at an annualized growth rate of 10%, growth in commercial
bank credit slowed to a below “normal’ rate of 6.5% in the three months ended
June 2015.
Chart 3
Again, the current behavior of thin-air credit does not
portend an acceleration in the rate of price increases for goods/services or
assets. And the recent behavior of these price changes would not seem to
warrant concern by the Fed. Consumer price inflation, as represented by the
Personal Consumption Expenditure price index, remains tame. In the three months
ended May 2015, this measure of consumer price inflation had increased at an
annualized rate of 2.2%, recovering from the price declines earlier in the year
due to falling energy prices (see Chart 4). Commodity prices of all stripes
have been trending lower in recent months, as shown in Chart 5. And asset
prices are not racing to the moon (See Chart 6).
Chart 4
Chart 5
Chart 6
So, current inflationary pressures are quite mild here in
the U.S. The current rate of growth in U.S. thin-air credit is below its
“normal” rate, suggesting that credit creation is not fostering a future surge
in U.S. inflation. And the global inflationary environment appears equally
tranquil, if not more so. The Chinese economy, which already had experienced a
growth slowdown, will now be negatively affected by its recent stock market
swoon. And Europe is not exactly booming, Greece aside. Given all this, it is
not clear what is motivating the Fed’s desire to raise its policy interest
rates sometime later this year. Whatever the motivation, if the Fed does pull
the interest-rate tightening trigger in 2015, it will not likely do so again
for many months thereafter. In other words, for Fed interest rate hikes in
2015, it’s one and done.
Paul L. Kasriel
Senior Economic and Investment Adviser
Legacy Private Trust Company of Neenah, WI
Founder, Econtrarian, LLC
1-920-818-0236
