Thursday, 22 of February of 2018

Economics. Explained.  

Consumer Price Index

February 14, 2018

The CPI jumped 0.5% in January after having risen 0.2% in December and 0.3% in November .  During the past year the CPI has risen 2.1%, but in the past three months the rate of increase has quickened to 4.3%.

Excluding food and energy the CPI rose 0.3% in January after having risen 0.2% December and 0.1% in November.  Over the past year this so-called core rate of inflation has risen 1.8% but in the past three months it has accelerated to a 2.8% pace.  Clearly, inflation is on the upswing.  The question is still one of degree.

Food prices rose rose 0.2% in both December and January.  Food prices have risen 1.6% in the past twelve months.

Energy prices jumped 3.0% in January after having declined 0.22% in December.  These prices are always volatile on a month-to-month basis.   Over the past year energy prices have risen 5.9%.  The recent run-up in energy prices seems to reflect strengthening GDP growth around the world which is bolstering the demand for both crude oil and gasoline.  However, prices U.S. production is surging and inventory levels have begun to climb.  As a result, oil prices have recently declined from about $68 per barrel to about $60.   The Department of Energy expects oil prices to average $55.33 in 2018 slightly lower than where they are currently.

Excluding the volatile food and energy components, the so-called “core” CPI rose 0.3% in January after having risen 0.2% in December.  The year-over-year increase now stands at 1.8%.

The press noted that apparel prices jumped 1.7% in January which was the biggest increase in 30 years.  That is factually correct, but the press neglects to point out that apparel prices declined in each of the previous three months,and they have fallen 0.6% in the past year.  Given the availability of apparel online on a variety of websites, there is no way that apparel prices are going to risen much any time soon.

The most starting development in the CPI in recent years has been the dichotomy between the prices of goods (excluding the volatile food and energy components) and services.  For example, in the past year prices for goods have fallen 0.6% while prices for services have risen 2.6%.

With respect to goods prices, it appears that the internet has played a big role in reducing the prices of many goods.  Shoppers can instantly check the price of any particular item across a wide array of online and brick and mortar stores.  If merchants do not match the lowest price available, they risk losing the sale.  Thus, they are constantly competing with the lowest price available on the internet.  Looking at specific items in the CPI we find that prices have fallen for almost every major category in the past year.  New cars have fallen 1.3%, used cars have dropped 0.6%, appliances 1.4%, televisions 10.7%, audio equipment 15.1%, sporting goods 0.6%, toys 10.0%, information technology commodities (personal computers, software, and telephones) 3.5%.  Prices for all of these items are widely available on the internet and can be used as bargaining chips with a traditional brick and mortar retailer.

In sharp contrast prices of most services have risen.  Specifically, prices of services have risen 2.6% in the past year.  The increase in this  broad category has been led by shelter costs which have climbed 3.2%.  This undoubtedly reflects the shortages of both rental properties and homeowner occupied housing. Indeed, the vacancy rate for rental property is at a 30-year low. This steady rise in the cost of shelter  will continue for some time to come and, unlike monthly blips in food or energy, it is unlikely to reverse itself any time soon.

While the CPI, both overall and the core rate, have been very well contained in the first half of this year we believe that as the year progresses the core rate of inflation will have an upward bias  because of what has been happening to both shelter prices, gradually rising labor costs, and rising producer prices.  But on the flip side, the internet is keeping a lid on the prices of goods.  So while the CPI should edge higher in 2018, it is unlikely to explode.

The Fed’s preferred measure of inflation is not the CPI, but rather the personal consumption expenditures deflator, specifically the PCE deflator excluding the volatile food and energy components which is currently expanding at a 1.5% rate but is poised to head higher.  The Fed has a 2.0% inflation target.  However, going forward we have to watch out for the steady increases in shelter which, as noted above, is being pushed higher by the shortage of both rental properties and homeowner-occupied housing.   Shelter is a long-lasting problem and given its 33% weighting in the CPI it will introduce an upward bias to inflation for some time to come.  We also have to watch rising medical costs(prescription drug prices in particular) and the impact of higher wages triggered by the shortages of available workers in the labor market.

Why the difference between the CPI and the personal consumption expenditures deflator?  The CPI is a pure measure of inflation.  It measures changes in prices of a fixed basket of goods and services each month.

The personal consumption expenditures deflator is a weighted measure of inflation.  If consumers feel less wealthy in some month and decide to purchase inexpensive margarine instead of pricy butter, a weighted measure of inflation will give more weight to the lower priced good and, all other things being unchanged, will actually register a decline in that month.  Thus, what the deflator measures is a combination of both changes in prices and changes in consumer behavior.

As we see it, inflation is a measure of price change (the CPI).  It is not a mixture of price changes and changes in consumer behavior (the PCE deflator).  The core CPI currently is at 1.8%.  However, with the economy growing steadily, rents rising, and wage pressures climbing, the core inflation rate should pick up from 1.8% currently to  2.4% by yearend.  And because the core PCE increases at a rate roughly 0.5% slower than the core CPI, the core PCE should increase  1.8% in 2018.  Both rates are beginning to trend higher.

Keep in mind that real short-term interest rates are negative.  With the funds rate today at 1.3% and the year-over-year increase in the CPI at 2.1% the “real” or inflation-adjusted funds rate is negative 0.8%.  Over the past 57 years that “real” rate has averaged about plus 1.0% which should be regarded as a “neutral” real rate.  Given a likely pickup in GDP growth this year and next and a gradual increase in the inflation rate, we regard a negative real interest rate inappropriate in today’s world.  The Fed should continue to push rates higher and gradually run off some of its longer term securities.

Stephen Slifer


Charleston, SC

Small Business Optimism

February 13, 2018

Small business optimism rose 2.0 points in January to 106.9 after having declined 2.6 points in December.

NFIB President Juanita Duggan said, “Main Street is roaring.  Small business owners are not only reporting better profits, but they’re also ready to grow and expand. The record level of enthusiasm for expansion follows a year of record-breaking optimism among small businesses.”

NFIB Chief Economist added that, “The historically high index readings over the last year tell us small business owners have never been more positive about the economy. This is in large response to the new management in Washington tackling the biggest concerns of small business owners – high taxes and regulations.”

In our opinion the economy is expected to gather momentum in coming months in response to a number of significant policy changes.  Specifically, we believe that the cut in the corporate income tax rate, legislation that will allow firms to repatriate corporate earnings currently locked overseas back to the U.S. at a favorable 15.5% rate, and the steady elimination of unnecessary, confusing and overlapping federal regulations will boost investment.  That, in turn, should boost our economic speed limit should from 1.8% or so today to 2.8% within a few years.

Already we see the stock market close a record high level despite the recent correction.   Jobs are being created at a reasonably robust pace.  The unemployment rate is below the full employment threshold.  The housing sector is continuing to climb.  And now investment spending should pick up after essentially no growth in the past three years.  We expect GDP growth to climb from 2.5% in 2017 to 2.9% in 2018.  The core inflation will  climb from 1.7% in 2017 to 2.5% in 2018.  The Fed will continue to raise short-term interest rates very slowly.  Accelerating GDP growth, low inflation, and low interest rates should propel the stock market to new record high levels.

Stephen Slifer


Charleston, SC

A Stock Market Event, Not an Economic Event

February 9, 2018

The S&P 500 index has now retreated 10% from its record high level which means that it has officially experienced a “correction”.  The decline was triggered by a report that wages have risen 2.7% in the past year which suggested to some market participants that the economy is overheating, inflation is about to accelerate, and the Fed could raise interest rates more quickly than anticipated.  News that the budget deal will increase the deficit by $300 billion over the next two years further spooked the bond market and exacerbated the stock market drop.

From an investor’s viewpoint perhaps more troubling than the magnitude of the drop, was the volatility that occurred during the week.  The Dow Jones Industrial Index declined 665 points on Friday, plunged an additional 1,175 points the following Monday, rebounded 567 points on Tuesday, only to resume its slide with a 1,033-point drop on Thursday.

As a result, the Vix Index of volatility soared.  Our sense is that with the steady ascent of the stock market over the past year, some investors had a risk profile that was probably acceptable in the low volatility environment that has existed for the past two years, but their positions became intolerable once volatility surged and they panicked.

Interestingly, economists have not changed their view about the economy.  They continue to expect GDP growth to pick up to some degree this year, they believe inflation will also climb but only slightly, and they continue to anticipate three or perhaps four rate hikes by the Fed.  With tax cuts on the way, a pickup in investment spending already positively impacting growth, and still low interest rates, that view seems well-justified.  We believe that the recent stock market selloff is a speed bump that will have little discernable impact on either economic growth or inflation.

Having said that we respect the market and, given this hiccough, we should pay close attention to the data going forward.  Is there any hint that the economy is overheating?  Is inflation headed higher than we expect?  Is the Fed under the leadership of a new chairman likely to change its game plan and accelerate the pace of interest rate hikes?

The next potentially market-moving piece of information will be the CPI report for January which will be released on Wednesday morning, February 14.  The market is expecting the so-called “core CPI”, which excludes the volatile food and energy components, to increase 0.2% in January.  If so, the year-over-year increase will slip from 1.8% currently to 1.6% and perhaps eliminate some of the fear of higher inflation.

The increase in the overall CPI index will also get some attention but, regardless of the outcome for January, keep in mind that crude oil prices plunged this past week as U.S. production soared and crude inventories began to build.  If sustained, which seems likely, this will keep the inflation rate in check for months to come.

On Wednesday we will get a look at retail sales for January.  This is important because it is the first month of the quarter and determines the goods portion of consumption spending for that month.  Since consumer spending is two-thirds of GDP it will help economists refine their estimates of first quarter GDP growth.  Like the CPI, economists strip out the volatile categories, like autos and gasoline, to derive “core retail sales”.  This series has been strong for the past six months with an average monthly increase of 0.6% some of which undoubtedly reflects post-hurricane rebuilding which should soon begin to taper off.

On Thursday the Federal Reserve will release industrial production data for January.  The focus will be on the change in production in the manufacturing sector.  (The mining category largely reflects changes in oil prices, and the utility component is whipsawed by unusually cold or snowy weather which is subsequently reversed.)  The manufacturing sector has been gathering momentum.  Orders have been steadily climbing, and production has risen 2.5% in the past year or 0.2% per month.

Then, there is the all-important employment report for February which will be released on March 2.  The markets will anticipate an increase in employment of 180 thousand and no change in the 4.1% unemployment rate.  But the focus will undoubtedly be on the change in average hourly earnings.  It has been increasing 0.3% per month since October.  Another 0.3% increase will boost the year-over-year increase from 2.7% to 2.9%.   The pickup to 2.7% a month ago is what triggered the initial market drop on Friday morning, February 2.  While the year-over-year increase might climb to 2.9%, a steady diet of monthly increases of 0.3% will eventually boost the annual increase to 3.6%.  While fatter paychecks are a good thing, the market may not see it that way.  As we have pointed out on numerous occasions, more rapid wage growth can be partially or entirely offset by a commensurate increase in productivity and that is what we expect.  But that is a story for another day.  We will not see productivity and unit labor cost data for the first quarter until the end of April.

The bottom line is that markets have become nervous about the possibility of the economy overheating, inflation on the rise, and an expedited pace of Fed tightening.  We think market fears are overblown.  However, turn downs in the economy are always foreshadowed by declines in the stock market.  Consumers and businesses are seemingly unaffected by the recent 10% drop.  But what if stock prices fall by an additional 10% and we experience a full-blown bear market?  Will consumers and the business community continue to maintain the faith?  Such a scenario could be more problematic.  We do not expect that to happen.  But for our moderate growth/ moderate inflation/slow Fed tightening scenario to be accurate, we need confirmation from the data.  We think we will ultimately get that reassurance, but it is important to constantly monitor the tea leaves.

Stephen Slifer


Charleston, S.C.

Trade-Weighted Dollar

February 6 2018

The trade-weighted value of the dollar, which represents the value of the dollar against the currencies of a broad group of U.S. trading partners has fallen 8.0% from where it was at this time last year.

When you try to figure out the impact of currency movements on our trade, you have to weigh the movements depending upon the volume of trade we do with that country.  For example, our largest trading partners are:

With respect to the Chinese yuan the dollar has weakened  about 8.3% over the past year.  A year ago one dollar would buy 6.87 yuan.  Today it buys 6.30 yuan.

The U.S. dollar has weakened 5.9% versus the Canadian dollar during the past year.  For example, a year ago one U.S. dollar would purchase $1.31 Canadian dollars.  Today it will buy $1.23 Canadian dollars.

And against the Mexican peso the dollar has weakened by 9.1% during the past year.  A year ago one dollar would buy 20.3 Mexican pesos.  Today it will buy 18.4 pesos.

The dollar has weakened by 2.6% against the yen during the course of the past year.  A year ago one dollar would buy 112.9 yen.  Today that same one dollar will buy 109.9  yen.

The dollar has weakened 17.0% relative to the Euro during the past year.  A year ago one Euro cost $1.065.  Today one Euro costs $1.245.

Thus, the dollar has weakened against every major currency during the course of the past year.   As a result, the trade-weighted value of the dollar, as noted earlier, has fallen 8.0% during the past year.

Currency changes can affect the economy in several ways.   First, a falling dollar can increase GDP growth of U.S. exports because U.S. goods are now cheaper for foreign purchasers to buy.  Similarly, a falling dollar can reduce growth of imports because foreign goods are now more expensive for Americans to buy.  More exports and fewer imports will boost GDP growth that year.  A falling dollar can also increase the rate of inflation in the U.S. because the prices of foreign goods are now higher.  A rising dollar will do the opposite — reduced growth in exports, faster growth in imports, and a lower rate of inflation.

From October 2014 to January 2016 the dollar rose 22%.  That is a huge change.  The trade component subtracted about 0.5% from GDP growth in both 2014 and 2015.

Given a 6.0% drop in the value of the dollar in 2017 the trade component of GDP will add about 0.2% to GDP growth in that year.  The weaker dollar seems to reflect the perception that GDP growth in Europe is picking up more quickly than it is in the U.S. and, simultaneously an expectation that the European Central Bank will soon begin to raise rates.  It is not exactly clear to us that is the case.  GDP growth seems to be accelerating quickly both in the U.S. and Europe.  It is hard to tell if growth in one area is accelerating more rapidly than in the other.  The same is true with interest rates.  We know the path the Fed has chosen — a very slow but steady path towards higher rates.  The Europeans have not yet begun that process.  Once they start they will undoubtedly proceed with caution.

But now we have Treasury Secretary Mnuchin suggesting that a “weaker dollar is good for trade”.  That is in sharp contrast to the long-held notion that a strong dollar is good for the U.S.  A weaker dollar may benefit the U.S. in the short term by boosting GDP growth and helping to keep the inflation rate in check.  But the Treasury also has large and increasing budget deficits which are expected to once again surpass  $1.0 trillion in a few years.  If the dollar should begin an extended slide, foreign central banks (the Chinese in particular) could become somewhat less willing to purchase large amounts of Treasury securities.  But this president and this administration are known for saying one thing one day and something different the next.  We’ll see.  On balance, we expect the dollar to fall about 3.0% this year.  If that is the case, it will add little, perhaps 0.1% to GDP growth this year and, similarly, have a minor impact on the inflation rate.

Stephen Slifer


Charleston, SC

S&P 500 Stock Prices

February 6, 2018

The S&P has fallen about 8.5% since reaching the latest record high level in late January.   But this should be regarded as a stock market event not an economic event.

The catalyst was average hourly earnings data for January which have now risen 2.9% in the past year.  That is the fastest growth in hourly earnings thus far in the business cycle.  So the fear is that, at last the economy is overheating, inflation has begun to climb and, therefore, the Fed will raise rates more than the three times than it has penciled in for 2018.

The economy is likely to increase about 2.9% this year which is faster than the 2.5% increase reported for 2017.  That will put some upward pressure on the inflation rate, but the question is how much pressure.  Our sense is that it will be modest with the core CPI rising 2.2 in 2018 versus 1.8% last year.  That is fairly close to the 2.0% Fed target for inflation and unlikely to spur it to raise rates more quickly.

IT is important to remember that wage pressure can be offset by gains in productivity.  If I pay you 3% more money and you are no more productive, my labor costs just rose by 3.0% and I may well choose to raise my prices as a result.  But if I pay you 3% more money because you area 3% more productive and I am getting 3% more output, I do not care.  In that situation I have no incentive to raise prices.  Thus, the appropriate gauge of upward pressure on the inflation rate from the seemingly tight labor market is labor costs adjusted for the increase in productivity or what economists call “unit labor costs”.

In the past year unit labor costs have risen 1.3% consisting of a 2.4% increase in productivity partially offset by a 1.1% increase in productivity.  For 2018 we expect labor costs to climb to 3.0%, but given the burst of investment spending (which is the primary determinant of growth in productivity) we expect productivity growth to climb to 1.8%.  Hence, unit labor costs this year should rise by 1.2% which is virtually identical to what it was last year.  A 1.2% increase in unit labor costs will not put upward pressure on the Fed’s 2.0% inflation target.

People are watching the wrong thing.  They are watching average hourly earnings when they should be watching unit labor costs.  If it begins to climb to 2.5-3.0% then we have a legitimate chance of inflation climbing above the Fed’s 2.0% inflation target.  We are not even close.

Stephen Slifer


Charleston, SC

Unemployment vs. Job Openings

February 6, 2018

This release is generally rather obscure.  Bu. Fed Chairwoman Janet Yellen often refereds to data from it so its importance has increased in recent years.

The  Labor Department reported that job openings fell 2.8% in December to 5,811 thousand after having risen 0.8% in October .    It is worth noting that there are more job openings today than there were prior to the recession (4,123 thousand in December 2007).   There were 6.6 million people unemployed in Decemer.

As shown in the chart below, there are currently 1.1 unemployed workers for every available job.   Prior to the recession this ratio stood at 1.7 so the labor market (at least by this measure) is in better shape now than it was prior to the recession.

In  this same report the Labor Department indicated that the quit rate in December rose 0.1 to 2.2.  The highest reading thus far in the business cycle of 2.2 has been attained on several occasions in recent months.  This series has been bouncing around between 2.1 and 2.2 for the  past two years.  This is a measure of the number of people that voluntarily quit their jobs in that  month.  During the height of the recession very few people were voluntarily quitting because jobs were scarce.  So the more this series rises, the more comfortable workers are in leaving their current job to seek another one.  The quit rate today is 2.2 at the beginning of the recession it was at 2.0.  Thus, it is not clear exactly how high this series can go.  Probably not a lot higher.

There is one other point that should be made about this report.  Janet Yellen claims that there are a large number of unemployed workers just waiting for jobs if only the economy were to grow fast enough.  She is assuming that these people have the skills and are qualified for employment.  We tend to disagree.  There are plenty of job openings out there.  What is not happening as quickly is hiring.  Take a look at the chart below.  Job openings (the green line) have been rising rapidly (and are higher now than they were prior to the recession); hires (the red line) have been rising less rapidly.

Indeed, if one looks at the ratio of openings to hires the reality is that this ratio  has not been higher at any point in time since this series began in 2000.  There are plenty of jobs out there, but employers are having a hard time filling them.  Why is that?

A couple of thoughts come to mind.  First and foremost, many unemployed workers simply do not have the skills required for the jobs available.  If they did, why aren’t they being hired?  Why aren’t some current part time workers stepping into the void for those full time positions? Why haven’t discouraged workers begun to seek employment with so many jobs available?  Why haven’t long-term unemployed workers bothered to go back to school and acquire the skills that are necessary to land a  job?

Or perhaps many of these people flunk the drug tests.  They might not be qualified for employment for a variety of possible reasons.

Perhaps also some people in this group find the combination of unemployment benefits and/or welfare benefits sufficiently attractive that there is little incentive to take a full time job when you can sit at home do nothing and make almost as much.

Whatever the case, it appears that the decline in the unemployment rate in the past couple of years is not simply a reflection of workers dropping out of the labor force.  Jobs are plentiful and the only reason the unemployment rate is not falling faster is because the remaining unemployed/discouraged/part time workers do not have the skills required by employers today, flunk the drug tests, or are unwilling to take the jobs that are available.

Stephen Slifer


Charleston, SC

Trade Deficit

February 6, 2018

The trade deficit for December widened by $2.7 billion to $53.1 billion after having widened by $1.6 billion in November.     Exports rose 1.6%.  Imports rose by 2.6%.

Frequently exports and imports can be shifted around by price changes rather than the volume of exports and imports.  Thus, what is really important is the trade deficit in real terms because that is what goes into the GDP data.  The “real” trade deficit was widened by $2.0 billion in December to $68.4 billion after having widened by $0.9 billion in November.

Increasing energy production in the U.S. is having a significant impact on our trade deficit in oil.  Since 2007 real oil exports have almost quadrupled from $3.0 billion to $11.0 billion, while real oil imports have fallen from $20.0 billion to $17.0 billion. As a result, the real trade deficit in oil has been cut by about $12.0 billion or 66% in the past several years and is the smallest since the early 1990’s.  Most energy exports believe that by the end of the decade the U.S. will not only surpass Saudi Arabia and Russia  and become the world’s biggest producer of oil, but also become a net exporter of oil.  Very impressive!  And now with U.S. producers allowed to export oil, that could happen even sooner.

Significant strength or weakness in the dollar can impact the trade deficit for any given period of time.  For example, the dramatic 22% rise in the value of the dollar from October 2014 through the end of 2015 subtracted about 0.5% from GDP growth in both 2014 and 2015.  But the dollar has about 8% in the past year.  As a result, we expect the trade component to add about 0.3% to GDP growth in 2018.

The non-oil trade gap has widened significantly in the past year to about $66.0 billion as non-oil exports rose 3.9% while non-oil imports climbed by 8.6%.

Stephen Slifer


Charleston, SC

Homeownership Rates

February 5, 2018

Homeownership edged upwards by 0.2% in the fourth quarter to 64.2%.  It hit a low of 62.9% in the second quarter of 2016 and has rebounded slightly.  It appears to have hit bottom.

The upswing in homeownership in the past two years   has been most pronounced amongst younger borrowers, i.e., those under the age of 45.  That is where most of the earlier decline occurred.

One factor contributing the steady decline in homeownership amongst our youth is the higher mortgage payment required to purchase a median-priced home which has risen 68% in the past five years risen from $612 in January 2013 to $977 currently.  Many younger borrowers simply cannot afford those higher payments.

As home prices have risen the down payment required to purchase a median-priced home has risen from $34,200 to $49,600 in the same five-year time period.

At the same time many younger borrowers are saddled with a considerable amount of student debt which will negatively impact their ability to qualify for a mortgage.  Such loans have been climbing at a double-digit pace since the recession began in December 2007 and are, in fact, the only type of consumer credit that has risen significantly during that period of time.

Finally, the very limited supply of homes available to purchase means that some potential home buyers simply cannot find a suitable property to purchase.

While younger adults have been negatively impacted by higher home prices, the fact remains that mortgage rates are still very low at 4.1%  and home prices are still about 6.0% below their 2006 peak value.  With a robust pace of jobs growth, it is likely that the steady decline in homeownership has ended, although it is difficult to envision a significant rebound in ownership any time soon.

As many former homeowners and younger people turn to renting, vacancy rates for rental properties have been falling fast and at 6.9% are the lowest they have been since the mid-1980’s.  There continues to be a significant housing shortage in the United States.  This implies that home sales and prices will continue to climb.  The shortage of rental properties is especially acute so look for builders to shift construction from single-family homes into this highly sought category.

Stephen Slifer


Charleston, SC

Purchasing Managers Index — Nonmanufacturing

February 5, 2018

The Institute for Supply Management not only publishes an index of manufacturing activity each month, they publish two days later a survey of non-manufacturing firms — which largely consists of services. The business activity index rose 2.1 points in January to 59.8 after having declined 3.3 points in December.   Comments included “post holiday pickup” and “new customer dollars available for spending in the new year.”  In January, 11 of 17 service-sector  industries  reported expansion.  Good, solid, broad-based growth at a relatively high level.  At its January level the non-manufacturing index equates to GDP growth of 4.0%.

The orders component  jumped 8.2 points in January to 62.7 after having declined 4.3 points in December .  Orders continued to flow in in January.  One of the strongest months thus far in the expansion.

The ISM non-manufacturing index for employment jumped 5.3 points in January to 61.6 after having risen 0.9 point in December.   This is by far the highest level thus far in the business cycle.  Jobs growth should continue in upcoming months at about the same pace we  have seen of roughly 180 thousand per month.

Finally,  the price component rose 2.0 points in January to 61.9 after having declined 0.2 point in December.   That is the eighth consecutive monthly increase (above 50.0).  It is clear that non-manufacturing firms are encountering higher prices for their materials.

Stephen Slifer


Charleston, SC

Federal Reserve’s Balance Sheet — Total Assets

February 5, 2018

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 has remained essentially unchanged for the past three years.  It consists of $2.5 trillion of U.S. Treasury securities, $1.7 trillion of mortgages, and $0.3 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 will reduce it by $20 per month in the first quarter of this year, $30 per month in the second quarter, $40 billion in the third quarter, and $50 billion in the fourth quarter of this year.  Thereafter, it will let its portfolio shrink by $50 billion per month until it reaches the desired size.  Thus, its portfolio may not get back to its target level until the end of 2022 or so.

Stephen Slifer


Charleston, SC