May 19, 2016
A June Fed Funds Rate Hike Risks a
September Economic Stall
Recent economic data, e.g., retail sales, housing starts
and industrial production, suggest that the U.S. economy has awoken from its
winter slumber. In addition, growth in consumer prices has accelerated of late
(see Chart 1). The consensus of the Federal Open Market Committee (FOMC) is
that the federal funds rate will be hiked twice by 25 basis points each time in
2016. Time’s a wastin’. The behavior of
short-term interest rates indicates that investors have been skeptical that the
Fed will pull the fed-funds trigger at its June 14-15 FOMC meeting. But about a
month ago, comments
by Boston Fed President Eric Rosengren, no Johnny-One-Note policy hawk like
Richmond Fed President Jeffrey Lacker, were interpreted to imply that
financial-market participants were underestimating how soon the Fed might hike
the federal funds interest rate.
Chart 1
Despite the recent acceleration in the pace of U.S.
economic activity, I believe that the Fed runs the risk of causing the pace of
U.S. economic activity to stall out in the late-summer or early-fall of 2016 if
it raises the federal funds rate at its June 14-15 FOMC meeting. The reason I
believe an economic stall would occur is, you guessed it, because of the negative
effect a fed funds rate hike would have on growth in thin-air credit (the sum
of the monetary base and depository institution credit).
Allow me to elaborate. The federal funds interest rate is
the price of overnight credit in immediately-available funds, or reserves,
created by the Fed. This price, like any price, is determined by supply and
demand. The demand for reserves is
determined by the amount of reserves depository institutions (primarily
commercial banks) are required to hold in relation to their deposits.
Depository institutions also have a demand for reserves in excess of what they
are required to hold. Now that the Fed pays interest on reserves held by
depository institutions, this excess demand for reserves is much higher than
was the case when no interest was paid by the Fed on reserves. The supply of reserves is determined by the
Fed. For example, if the Fed sells securities in the open market, the supply of
reserves will decrease, all else the same. If the Fed wants the federal funds
rate to rise, it needs to reduce the
supply of reserves relative to the demand for reserves. When the Fed raised the federal funds rate in late
December of 2015, the monetary base – the sum of reserves and currency in
circulation – declined (see Chart 2).
And, although the level of the monetary base rose subsequent to its dip
coincident to the increase in the fed funds rate, the level of the monetary
base has not returned to its level prior to the increase in the fed funds rate.
Chart 2
Now, let’s look at the recent behavior of a variant of
thin-air credit, i.e., the sum of the monetary base and commercial bank credit.
Chart 3 shows the annualized growth in this variant of thin-air credit on a
three-month basis. In the three months
ended October 2015, thin-air credit had grown at an annual rate of 6.7%, close
to its long-run median annualized growth rate of about 7%. By the three months
ended January 2016, annualized growth in thin-air credit had slowed to just
1.1%. In the three months ended April 2016, annualized growth in thin-air
credit had recovered to 3.8%. But that was still well below its long-run median
annualized growth of 7%.
Chart 3
Now let’s reproduce the data in Chart 3, the three-month
annualized growth in thin-air credit, but also show the three-month annualized
growth in its components, commercial bank credit and the monetary base. This is
shown in Chart 4. We can see that in March and April 2016, the three-month
annualized rate of growth in commercial bank credit has moderated (6.0% in the
three-months ended April 2016). Although the monetary base still is
contracting, its rate of contraction has become less, only minus 2.5% annualized in the three months ended April 2016. If
the Fed raises the federal funds rate in June, the contraction in the monetary
base will likely become more severe, as it did after the December 2015 hike in
the federal funds rate. Unless growth in commercial bank credit surges for some
reason, a June increase in the federal funds rate implies further slowing in
the growth to total thin-air credit from an already slow rate of growth. In
turn, this would imply future slowing in the pace of nominal economic activity
from a none-to-robust current pace.
Chart 4
If the Fed decides to raise the federal funds rate in
June, I would expect a rally in the prices of investment-grade U.S. bonds. At
the same time, I would expect a decline in the prices of riskier financial
assets.
Paul L. Kasriel
Senior Economic and Investment Advisor
Founder and Outplacement Officer of Econtrarian, LLC
1-920-818-0236
