November 24, 2013
Unless the Fed Goes Cold Turkey on Us, Expect a
Bountiful Economic Harvest for Thanksgiving 2014
If
your Thanksgiving family dinner conversation is anything like mine this
Thursday, it will be dominated by a discussion of how the U.S. economy and its
financial markets will be behaving after nearly a year of Dr. Janet Yellen at
the helm of the Fed. Well, I am going to give my family an advance copy of what
I plan to say so that we can just concentrate on willing a Packers victory over
the Lions. As a preview, I am bullish
about what things will look like by Turkey
Day 2014 even if Chairwoman Yellen becomes a little hawkish. (Perhaps too cute with the animal references?)
Let
me explain. Monetary policy is all about modulating nominal aggregate
transactions. Monetary policy affects the amount of a certain kind of credit created
in the economy -- credit that is created, figuratively, out of thin air. An
increase in this thin-air credit enables the recipients of it to increase their
purchases of goods, services and/or assets – physical and financial – without
necessitating anyone else to correspondingly reduce his current
spending/transactions. Regrettably, there do not exist data of total
transactions in the U.S. economy. But there is a measure calculated by the
Bureau of Economic Analysis that is an estimate of the nominal dollar amount of
expenditures by U.S. residents on currently-produced goods and services, some
of which are produced domestically, some of which are produced abroad. This
measure is called nominal Gross Domestic Purchases.
Plotted
in Chart 1 are year-over-year percent changes in quarterly observations of
nominal Gross Domestic Purchases and the sum
of Federal Reserve credit and depository institution credit from 1953:Q1
through 2013:Q2. As I have discussed ad
nauseam in previous commentaries, both Fed credit and depository
institution credit are created, figuratively, out of thin air. The measure of
Fed credit included in the credit sum is another sum – the sum of Fed outright
holdings of securities and Fed holdings of securities via repurchase
agreements. The Fed’s current Quantitative Easing (QE) policy involves
increased outright acquisitions of securities. Depository institution credit
consists of the loans and securities on the books of institutions that issue
deposits redeemable at par – commercial banks, saving institutions and credit
unions. Since the S&L crisis of the early 1990s and the financial crisis of
2008, commercial banks account for the overwhelming largest component of
depository institution credit.
Notice in Chart 1 that changes in the sum of
Fed and depository institution credit, advanced by one quarter, has a
correlation coefficient of 0.65 (out of a possible maximum of 1.00) with
changes in the sum of nominal Gross Domestic Purchases. This correlation of
0.65 is higher than that obtained when the two series are compared on a coincident
basis. This correlation is higher than that obtained when changes in nominal
Gross Domestic Purchases is advanced one quarter relative to changes in the sum
of Fed and depository institution credit. Thus,
the evidence in Chart 1 suggests that not only do changes in nominal Gross
Domestic Purchases and changes in the sum of Fed credit and depository
institution credit move in close tandem, but also that changes in the sum of
Fed and depository institution credit “cause” (in a statistical sense) changes
in nominal Gross Domestic Purchases.
Chart 1
Plotted
in Chart 2 are year-over-year percent changes in the sum of Fed and depository institution credit along with changes in
depository institution credit by itself. From 1953 through 2008, the
year-over-year percent changes in both of these series were very close to being
equal. This implies that from 1953 through 2008, up until the recent financial
crisis and the advent of QE, the behavior of depository institution credit
dominated the behavior of the sum of
Fed and depository institution credit. In other words, the Fed was providing a
relatively small amount of “seed money” for thin-air credit creation to
depository institutions. Depository institutions, operating in a fractional
required reserve monetary system, were “multiplying” this Fed seed money into a
much larger amount of thin-air credit to the non-depository-institution public.
Chart 2
Chart
3 shows this more explicitly. Depository institution credit as a percent of the
sum of Fed and depository institution
credit has a median value of 92.3% from 1953:Q1 through 2013:Q2. In 2013:Q2,
this percentage had dropped to a low of 78.2%. As implied in Chart 3, following
the financial crisis of 2008, the Fed has become a considerably larger provider
of total thin-air credit as private
depository institutions have had to restrict their thin-air credit creation
because of capital constraints resulting from loan losses as well as increased
regulatory capital requirements.
Chart 3
Chart
4 shows the actual year-over-year
percent change in quarterly observations of nominal Gross Domestic Purchases
along with the predicted changes in
the same. The predicted values were obtained from a linear OLS regression I ran
with percent changes in nominal Gross Domestic Purchases as the dependent variable. The explanatory variables were a constant
term, lagged percent changes in the
sum of Fed and depository institution credit and lagged values of the percent changes in nominal Gross Domestic
Purchases. Looks like a tighter fit than OJ’s glove, eh? The adjusted R-squared
for this regression is 0.87, which means that the explanatory variables
“explain” 87 percent of the variation in percent changes in nominal Gross
Domestic Purchases.
Chart 4
Alright,
so why am I bullish on nominal transactions for 2014? Because I am expecting
the key “mover” of nominal transactions, the sum of Fed and depository
institution credit, to average year-over-year growth from now through the end
of 2014 slightly above its long-term
median growth of 7.6% . Sustained
growth in total thin-air credit of this magnitude has not occurred since the
mid 2000s. I am making very conservative assumptions about the behavior of Fed
credit and depository institution credit in my calculation of the projected sum
of Fed and depository institution credit. I am assuming that the Fed will taper
its net acquisitions of securities by $10 billion per month starting in January
2013 and taper further by another $10 billion per month starting in July 2014.
In the 12 months ended October 2013, commercial bank credit increased 0.9%. I
am assuming that depository institution credit will continue to grow at this
modest rate. Chart 5 shows the actual year-over-year growth in the sum of Fed
and depository institution credit from 2000:Q1 through 2013:Q2 and my projected growth in it from 2013:Q3
through 2014:Q4. The projected average year-over-year growth for the six
quarters ended 2014 is 7.8%.
Chart 5
Plugging
these conservative projected growth rates for the sum of Fed and depository
institution credit into my aforementioned regression, I obtained forecasts of
year-over-year percent changes in nominal Gross Domestic Purchases from 2013:Q3
through 2014:Q4. These forecasts, along with actual percent changes in nominal
Gross Domestic Purchases starting in 2000:Q1 are shown in Chart 6.
Chart 6
Notice
that the forecast shows a rising trend in year-over-year growth in nominal
Gross Domestic Purchases in the (shaded) 2013:Q4 through 2014:4 period. For
2014:Q4, the year-over-year growth forecast for nominal Gross Domestic
Purchases is 7.2%, the fastest year-over-year growth since 7.6% in 2005:Q4.
Now,
I do not view the point forecasts of nominal Gross Domestic Purchases as the
Gospel. But I do believe that the projected rising trend in the growth of the
sum of Fed and depository institution credit does portend a rising trend in the
growth of nominal Gross Domestic Purchases. Moreover, I believe that my growth
projections of the sum of Fed and depository institution credit are very
conservative. Given the capital-raising campaigns undertaken by U.S. depository
institutions in recent years, given the diminished uncertainty about future
regulatory capital requirements and given the rising trend in residential real estate
prices, I believe that depository institutions are more able to step up their credit creation. Lastly, if I have erred in
my projection of Fed credit, I suspect I have erred on the side of restraint.
It is not a done deal that the Fed will commence a tapering in its securities
purchases in the December 2013 or January 2014, as I have assumed, especially
given how low consumer inflation is. For example in the three months ended
October, the All-Items CPI increased at a compound annualized rate of 0.8%; the
CPI ex Food & Energy at 1.5%. If the Fed were to delay its initial round of
tapering until March 2014, it also would likely delay its second round of
tapering – i.e., initiating an additional amount per month of reduced
securities purchases – until after July 2014.
My
projection of a rising trend in the growth of the sum of Fed and depository institution
credit has a positive implication for the prices of U.S. risk assets –
equities, high-yield bonds, real estate and maybe even commodities. The
recipients of this projected rising trend of thin-air credit are going to
purchase something with it. If the
borrowers purchase currently-produced goods and services, this would result in
higher corporate profits, which, in turn, would be positive for equities and
high-yield bonds. The recipients of this increased supply of thin-air credit
might purchase risk assets directly. After all, margin credit is on the rise.
What
my projection of a rising trend in the growth of the sum of Fed and depository
institution credit has a distinctly negative implication for are the prices of
investment grade fixed-income securities. The likely faster growth in nominal
aggregate demand will have a “multiplier” impact on the effective demand for credit. That is, as growth in sales of goods
and services increases, businesses will be induced to borrow more to expand the
scale of their operations. Household creditworthiness will improve, inducing
them to activate their latent demand for credit. Rising credit demand will put
upward pressure on interest rates, especially interest rates on longer-maturity
securities. Presumably, interest rates on short-maturity securities will be
held in place by the Fed’s continued zero-interest-rate policy (ZIRP). But,
speaking of ZIRP, growth in nominal domestic aggregate demand higher than what
the consensus and the Fed expect (is making a distinction between consensus
expectations and Fed expectations a distinction without a difference?), which
is my expectation, will cause the
consensus to move up in time the forecast for the first Fed interest–rate hike and, therefore, revise up the level of
the expected future course of short-term interest rates. This will put upward
pressure on the current levels of
longer-maturity interest rates. Lastly, stronger-than-expected growth in
nominal domestic aggregate demand would likely result in an upward revision in
inflation expectations, also putting upward pressure on the current levels of
bond yields.
So,
as you gather around the dining table with your family this coming Thursday to
enjoy your Thanksgiving feast, you can reflect on not only your good fortune in
2013, but look forward to an even
more bountiful “harvest” at Thanksgiving 2014,
thanks, in no small part, to the generosity of the Federal Reserve. But you
might want to “put up” more of that expected bountiful 2014 harvest because the
Fed’s generosity will already have waned around the time of Thanksgiving 2014. The
Fed is likely to become downright miserly soon thereafter, which implies that
2015 will be a much leaner year.
Paul
L. Kasriel
Econtrarian,
LLC
1-920-818-0236
Sturgeon
Bay, WI
