July 17, 2017
Have
Bundesbank Agents Infiltrated the Fed?
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.
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.
Chart 1
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.
Chart 2
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 advanced 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 leads
consumer inflation by two years. So, what is happening to thin-air credit
growth today has its maximum effect
on consumer inflation two years later.
(This has important implications as to how U.S. monetary policy should be
conducted, but the discussion of this is for a later commentary.) 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 slow in 2017 and 2018 compared with 2015 and 2016.
Chart 3
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 lower in recent years, slowing to 2.6%
in the 12 months ended June 2017. Notice also that the federal funds rate has
been trending higher. Coincidence? I
don’t think so.
Chart 4
In order for the Fed to push the federal funds rate higher, it must
reduce the supply of the monetary base
relative to the demand for the
monetary base. Chart 5 shows that as the target level of the federal funds rate
was increased by one full percentage
point in the 19 months ended June 2017, the monetary base contracted by $308 billion.
Chart 5
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.
Chart 6
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 real 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 contracted
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).
Chart 7
Chart 8
Chart 9
Chart 10
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.
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?
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 rule
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 Politico article, Quarles is in favor of the Fed
using the Taylor Rule 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 wrong rule for
the Fed to adopt. Can you guess what might be involved in the rule I would
favor?
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, “Rake”. 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 50th anniversary gift from my wife, a beautifully restored
50-year old classic sailboat – a Pearson Commander 26. I will try to be more
productive, but sailing season up here in tundraland lasts until early October!
Paul L. Kasriel
Founder, Econtrarian,
LLC
Senior Economic and Investment Advisor
1-920-818-0236
“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte
