Wednesday, 22 of May of 2019

Economics. Explained.  

Category » Federal Reserve

M-2

April 18, 2019

Growth in the M-2 measure of the money supply  has been steadily slowing and is now growing at a 3.8% pace.

To know whether that rate is too fast or two slow, the Fed needs to look at the relationship between growth in the money supply and growth in nominal GDP.  Over the past 50 years the two have grown at almost exactly the same rate.  Or, to put that in econospeak, over time M-2 velocity averages about 0.0% but with a lot of variability from year to year.  Thus, if the money supply is growing at a 3.8% pace, then the Fed might expect nominal GDP to grow at that same 3.8% pace.

Unfortunately, it cannot determine how much of that growth rate will represent real GDP growth and how much will be inflation.  Currently, economists think that our economic speed limit, i.e., how fast the economy can grow without giving rise to inflation is about 2.0%.  If real GDP grows by 2.0%, then the Fed might end up with an inflation rate of about 1.9%.  You will recall that the Fed’s target for inflation is 2.0%.  But the economic speed limit appears to be accelerating because of more rapid growth in productivity.  If the speed limit has climbed to 2.5%, for example, then inflation would end up on target at 1.2%.  Having said that, all these numbers can be a little bit squishy and relationships change.  The point is that at the moment money growth is currently growing at a pace adequate to support a vigorous recovery, but not fast enough to trigger any significant upswing in inflation.

Stephen Slifer

NumberNomics

Charleston, SC


Federal Reserve’s Balance Sheet — Total Assets

April 1, 2019

The Federal Reserve’s balance sheet reflects the extent to which the Fed bought securities to support the economy since late 2008.  Prior to the recession, the Fed’s asset holdings were about $900 billion.  But then when the bottom dropped out, Lehman Brothers collapsed and the banking sector was on the verge of imploding, the Fed bought all sorts of securities in an effort to provide sufficient liquidity to the banking system to prevent a complete collapse of the financial sector.  Its balance sheet exploded from $900 billion to about $4.5 trillion.

Its balance sheet quickly rose from $900 billion in September 2008 to $2.2 trillion by the end of that year.

From the end of  2008 through the end of 2010 the Fed’s balance sheet then stayed relatively steady.  But at the end of 2010 the Fed decided that it was unhappy with the unemployment rate at almost 10% and it engaged in a second round of easing which as become known as QE2 (or Quantitative Easing 2).  They decided to purchase another $600 billion of securities which boosted its balance sheet to $2.8 trillion in an effort to push long-term interest rates lower, provide additional stimulus to the economy, and  (hopefully) push the unemployment rate sharply lower.

The third step in Fed easing occurred in September 2011.  They decided to sell $600 billion of Treasury bills and short-dated Treasury notes, and buy an equivalent amount of long-dated Treasuries.  By doing this “swap” the Fed did not further inflate its balance sheet.  The object was to push long rates lower and, hopefully, provide further stimulus to the housing market.  As a result the yield on the 10-year note fell to a record low level of 1.5% by the summer of 2012.

The fourth step in the Fed easing process came in September 2012 when the Fed indicated that it was not happy with the 8.1% level of the unemployment rate and wanted it to decline more quickly.  So to jump start the economy, the housing market in particular, it told us that it intended to buy $40 billion of mortgage-backed securities every month until such time as the unemployment rate declined to a more acceptable level.  That was in addition to its monthly purchases of $45 billion of Treasury securities.  That means that the Fed further increased the size of its balance sheet which has climbed from $2.8 trillion in September 2012 to its current size of to $4.5 trillion.

But the economy eventually progressed to the point where the Fed felt comfortable phasing out its monthly purchases of securities.  Indeed, it began to gradually trim its pace of buying securities from $85 billion per month ($45 billion of U.S. Treasuries and $40 billion of mortgages) at its peak in December 2013.  It cut its purchases by $10 billion at each FOMC meeting during 2014 and eliminated the program entirely by October of 2014.   Its portfolio then remained essentially unchanged for the past three years.  It consists of $2.25 trillion of U.S. Treasury securities, $1.65 trillion of mortgages, and $0.2 trillion of agencies, gold,  and other securities.

The Fed knows that it must shrink its portfolio to a more “normal” size.  It has said that it does not plan to sell securities outright to reduce the size of its balance sheet, but it does intend to gradually shrink its portfolio by allowing maturing securities to mature.  It started out slowly by reducing its portfolio $10 billion per month in the fourth quarter of 2017.  It then reduced it by $20 per month in the first quarter of 2018, $30 per month in the second quarter, $40 billion in the third quarter, and $50 billion in the fourth quarter.

However, in January 2019 it said that it plans to conclude the reduction in its holdings of securities at the end of September 2019.  That would leave its aggregate security holdings to stabilize at about $3.7 billion which is somewhat higher than required to efficiently implement monetary policy.  By so doing it clearly wants to avoid its policy from inadvertently becoming “too tight” and possibly causing the economy to slip into a premature recession.

Stephen Slifer

NumberNomics

Charleston, SC


Excess Reserves

April 1, 2019

Banks must maintain a certain percentage of their deposits in an account at the Fed known as that bank’s “reserve” account.  Because they do not want to overdraw their account, prudent bankers always seek to hold just a little bit extra.  This little bit extra is known as “excess” reserves.  Prior to the recent recession that “little bit extra” added up over all the banks in the banking system, was a little bit less than $2.0 billion. During the recession when liquidity in the banking system dried up, the Fed essentially put the pedal to the metal and started stuffing reserves into the banking system right and left.  Its overriding objective was to get the economy moving again and, indeed, it succeeded.  The economy turned around in June 2009 which was sooner than many economists had anticipated.  But now the Fed has a problem.  Excess reserves in the banking system today are $2.2 trillion (with a T, not a B).  Those reserves represent funds that could be lent out by banks to fuel a spending spree the likes of which we have never before experienced.  They are, in some sense, “ammo” available to the banking system for lending.

Between the collapse of Lehman Brothers in September 2008 and the end of that year, excess reserves rose quickly from $1 billion to $900 billion.

At the end of 2010 the Fed decided that it was unhappy with the unemployment rate at almost 10% and it engaged in a second round of easing which as become known as QE2 (or Quantitative Easing 2).  They decided to purchase another $600 billion of Treasury securities at a pace of $45 billion per month, which quickly boosted excess reserves to $1.5 trillion.  The effort was designed to push long-term interest rates lower, provide additional stimulus to the economy, and  (hopefully) push the unemployment rate sharply lower.

The third step in Fed easing occurred in September 2011.  They decided to sell $600 billion of Treasury bills and short-dated Treasury notes, and buy an equivalent amount of long-dated Treasuries.  By doing this “swap” the Fed did not further inflate its balance sheet.  The object was to push long rates lower and, hopefully, provide further stimulus to the housing market.

The fourth step in the Fed easing process came in September 2012 when the Fed indicated that it was not happy with the 8.1% level of the unemployment rate and wanted it to decline more quickly.  So to jump start the economy, the housing market in particular, it told us that in addition to its purchases of $45 billion per month of U.S. Treasury securities, it also intended to buy $40 billion of mortgage-backed securities every month until such time as the unemployment rate declined to a more acceptable level.  That was in addition to the $45 billion of Treasury securities that it was purchasing every month.  As a result,  excess reserves have now climbed from $1.5 trillion to $2.7 trillion.

Thus, at its peak in late 2013 the Fed was purchasing $85 of long-dated securities every month — $45 billion of Treasury notes and bonds and $40 of mortgage backed securities.  The Fed began to slow its pace of purchases by $10 billion at every FOMC meeting during 2014.  It phased out its purchases of securities in October 2014.

The Fed knows that it must shrink its portfolio to a more “normal” size.  It began to gradually shrink its portfolio by allowing maturing securities to mature.  It started out slowly by reducing its portfolio $10 billion per month in the fourth quarter of 2017.  It then reduced it by $20 per month in the first quarter of 2018, $30 per month in the second quarter, $40 billion in the third quarter, and $50 billion in the fourth quarter.

It came up with a game plan on how  to eliminate the huge volume of excess reserves.  It can raise the rate of interest it pays to banks on their reserves account.  In that event, the excess reserves would still be there, but would effectively be neutralized.  Why lend money to you or me at 4% when banks can keep the money in their reserves account at the Fed, risk free at, say, 2.5%.  Indeed, he Fed has raised the rate it pays on excess reserves from 0.0%% to 2.4%.

However, in January 2019 it said that it plans to conclude the reduction in its holdings of securities at the end of September 2019.  That would leave its aggregate security holdings to stabilize at about $3.7 billion which is somewhat higher than required to efficiently implement monetary policy.

If the Fed stops shrinking its portfolio by the end of September, excess reserves in the banking system should stabilize at about $1.3 billion.  Nobody knows for sure if that level of excess reserves is appropriate.  What the Fed does know is that if all those reserves are used, inflation would skyrocket.  Clearly, the Fed can not and will not allow that to happen. The reserves for the most part currently are simply sitting in the equivalent of a checking account at the Federal Reserve.  They are not boosting the money supply, they are not being lent out extensively to consumers or businesses.   They are not in any way inflationary.  Why?  Because  both consumers and firms have been more interested in paying down debt than in adding to it.  For the first five years of the expansion their income has been going up, their outstanding debt has been going down, hence their “debt burden” became far more manageable.  For the past several years this ratio has remained steady at a level well below its average over the past 35 years

Meanwhile, total loan growth remains modest.  In the past year total loans have risen by 5.5%.  While slightly faster than in the  past couple of years, 5.5% loan growth is still moderate and sustainable.

But the real question is, will all of this work?  The Fed thinks it can pull it off.  But it is important to remember that they have never been in this situation before.  In the old days they might have to drain $2 billion of reserves.  Today they have to drain $1.5 trillion.  That is 750 times bigger than anything they have had to deal with in the past.  They may be successful, but the order of magnitude here creates the risk of unintended consequences.

Stephen Slifer

NumberNomics

Charleston, SC


Fed Funds Rate

March 29, 2019

The federal funds rate is the overnight rate that banks charge each other to borrow/lend  reserves.  Some banks have more reserves than they need.  Others (principally large banks) are short of reserves and must borrow from other banks in the system, typically on an overnight basis.  The rate at which this borrowing takes place is known as the fed funds rate.  It is the only rate that the Fed can directly control.  Most other short-term interest rates like Treasury bills, CD’s, commercial paper, etc. are very closely linked to this rate, so when the Fed tightens or eases all other short-term rates move in the same direction by essentially the same amount.

Once the recession began in December 2007 the Fed tried to stimulate the economy and ultimately pushed the funds rate almost to 0%.  It remained at that record low level until December 2015.

In December 2015 the Fed decided it was time to alter its policy and push the funds rate towards a more “neutral” policy stance.  So what might be regarded as a  “neutral” level for the funds rate?  The answer lies in the relationship between the funds rate and the inflation rate.  Whether an interest rate is high or low depends entirely on how it stacks up relative to the rate of inflation.  Think of it this way.  A 10% interest rate most of the time would be regarded as punishingly high.  But in the late 1970’s when the inflation rate was 12%, a 10% rate was actually quite cheap.  An investor could borrow at 10% for a year, buy an asset whose price would rise 12%, then pay back the 10% loan a year later and actually make money on the transaction.  So whether rates are high or low really depends upon their relationship to the rate of inflation.

The difference between the funds rate and the inflation rate is known as the “real” funds rate. Over the past 30 years, the funds rate has averaged 1.0% higher than the inflation rate.  As shown below, sometimes it will be higher than that, other times it will be lower.  But over time the “real” funds rate has averaged 1.0%.  Hence, the Fed would probably regard such a “real” funds rate as relatively “neutral”.  So if the Fed wants an inflation rate of 2%, and believes that its policy is neutral when the funds rate is 1.0% higher than that, then by implication a 3.0% funds rate in today’s world would be roughly “neutral”.  In more recent years the real funds rate has slipped a bit to 0.8%, thus the Fed now  believes that a neutral funds rate is about 2.8%.

But the funds rate today is not at 2.8%, it is 2.4%.  Thus, the Fed is still slightly below its assumed “neutral” rate.  At the same time the Fed has said it intends to leave the funds rate unchanged through the end of this year.  The U.S. economy has never dipped into recession until the Fed has pushed the funds rate higher than the so-called “neutral” rate.   In fact, as shown above, it had to raise the funds rate to 6.5% in 2000 and 5.25% in 2007 before the economy spiraled into recession.  We believe that at the 5.0% mark we should begin to pay attention for signs of a growth slowdown.  However, if the funds rate is 2.4% by the end of 2019 there is virtually no chance that such a level would be the catalyst for a recession.

 

Stephen Slifer

NumberNomics

Charleston, SC


Treasury Notes — 10-Year Maturity

March 29, 2019

The yield on the 10-year note has fallen 0.9% in the past couple of months from 4.9% to 4.0% in part because the Fed said that it was done tightening and the funds rate would be unchanged for the foreseeable future.  At the same time the 20% correction in the fourth quarter of last year created an expectation for slower growth ahead.  And the inflation rate has edged lower in recent months instead of rising as had been anticipated.  As a result, all long-term interest rates have declined sharply.

During the past several business cycles the 10-year note has averaged 2.0% higher than the inflation rate.  With the yield on the 10-year note today at 2.4%% and inflation at 1.7%, the real 10-year rate is 0.7% which is very low by any historical standard.

If the Fed keeps the inflation target at 2.0%  and the rate on the 10-year tends to average 2.0% higher than that, the yield on the 10-year should eventually reach 4.0%.  However, it should not rise to that level for some time if the inflation rate remains relatively steady.  At the end of 2019 we expect the yield on the 10-year note to climb slightly  to 2.75%

When will rates have risen high enough that the economy could dip into recession?  The yield curve — which is the difference between long-term interest rates and short rates — will give us a hint.   When the Fed tightens aggressively short rates typically move higher than long rates and the yield curve will “invert”.  When it does that is almost invariably a sign that the economy is about to dip into recession.  Thus, an inverted yield curve is a closely watched indicator that a recession may be approaching because it tells us that Fed policy is “too tight”.  Note how in both 2000 and 2007 the curve inverted by 0.5% or so six months to one year prior to the onset of recession.

Today, with the 10-year yield at 2.4% and the funds rate at 2.4%, the yield curve today is flat and some parts of the curve are slightly inverted.  However,  a curve that inverts because the Fed has raised short rates quickly and they eventually become higher than long rates is a danger signal because the inverted curve is a signal that Fed policy is “too tight”.  But in the recent case the curve has inverted slightly because long rates have fallen sharply and are now below short rates.  A curve that inverts because long rates have fallen sharply does not carry the same danger signal as when the curve inverts because short rates are rising rapidly.  There is a big difference.  The inverted curve today is not a harbinger of an impending recession

For us to make a recession call we need to see two things.  First, the funds rate will need to be well above the neutral rate (probably about 5.0%), and the yield curve should be inverted.  Neither of those conditions seem likely to be met by the end of 2019.

Stephen Slifer

NumberNomics

Charleston, SC