December 14, 2016
If
You Think the Pace of Economic Activity Is Weak in 2016, Just Wait Until 2017
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. 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. 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 leads
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 causal relationship with the behavior of
growth in Gross Domestic Purchases. 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.
Chart 1
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 not 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 “The Fed Began Tightening Policy in October and No One Knew
It, Maybe Not Even the Fed” for a discussion of this.) This has
resulted in the continued contraction in the monetary base in 2016. 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.
Chart 2
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. 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. 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.
Chart 3
The extreme weakness in the growth in the past three months of combined
commercial bank credit and the monetary is not
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.
Chart 4
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!
Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic and Investment Advisor
1-920-818-0236
“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
