Senin, 23 September 2013

Fed tightening is the real issue, not tapering

The timing of when the Fed begins to "taper" its purchases of Treasuries and MBS—currently running at $85 billion a month—has been the source of much market angst in recent weeks. Many expected the tapering to begin this month, but now the guessing is that it may start next month or in December. In any event, it's really much ado about nothing, and let me explain why. Briefly, QE hasn't done much to change the money supply; it hasn't done much to stimulate the economy; it hasn't been inflationary; and banks already have an almost unlimited ability to expand lending. Since massive amounts of QE haven't done much (if anything) to help the economy or to create unwanted inflation, then tapering QE by a small amount isn't likely to hurt the economy or create deflation. And since banks already have enough reserves to support virtually unlimited lending, reducing the growth of bank reserves by a small amount is not going to materially slow or discourage bank lending going forward. It's almost a non-event.

As the charts above show, the Fed's Quantitative Easing purchases of bonds have not resulted in any undue expansion of the money supply. Put another way, the Fed has NOT been "printing money" as so many seem to think. The M2 measure of the money supply, arguably the best measure we have, has been growing only slightly faster than its long-term average rate of about 6% per year for the past five years during which we've had plenty of QE. The second of the above charts shows this same process on a shorter time frame. On the surface, there is nothing unusual going on with the money supply, despite the Fed's purchases of $2.7 trillion of Treasuries and MBS since September 2008.

If there is anything unusual going on with the money supply, it is bank savings deposits (above chart). Coming out of the last recession, bank savings deposits started growing at a very fast 10-15% per year clip. In the past year, growth has slowed a bit to a 9-10% annual pace. Bank savings deposits are now up over $3 trillion dollars in the past four years. This rapid growth of savings deposits owes much to the public's demand for safe-haven assets. This is simply more evidence that the world's demand for "money" has been very strong, and the Fed has simply accommodated this demand. That is entirely appropriate and not inflationary.

When it finally happens, the first phase of the tapering of bond purchases will mean that instead of buying $85 billion of Treasuries and MBS per month, the Fed will be buying $65 billion per month. As the chart above shows, that is a fairly small change on the margin. Bank reserves now total some $2.3 trillion, so the Fed's monthly additions of $85 billion represent an expansion of the existing stock of reserves of less than 4%.

Despite the trillions of QE, despite four years during which money market rates have been close to zero, and despite the fact that the federal government has borrowed and spent an additional $4.7 trillion since mid-2009, the economy has experienced its weakest recovery ever. What's going on?

If the most massive package of monetary and fiscal stimulus in the history of our country has produced the weakest recovery on record, a layman could be forgiven for thinking that without all this buying, borrowing and spending by our government, we would be in a depression.

But there's another and better way to see this: When the government borrows, it takes money from someone. When it spends, it gives that money to someone else. It takes from Peter and gives to Paul. That is only "stimulative" if Paul ends up doing something more productive with the money than Peter would have if he had kept it. It's much more likely that all the borrowing and spending has worked to depress the economy, not stimulate it. That's because the bulk of the deficit-financed spending has gone to fund transfer payments. We've borrowed money from the productive members of society and given it to the non-productive sectors. The money has been spent unwisely, inefficiently, and even wasted. That's a perfect prescription for slow growth. (And of course there's all the money that has been handed out in the failed pursuit of "green" technologies, the huge subsidies to agriculture, and the multitude of deductions in our tax code which basically amount to corporate welfare.) In short, the "spending multiplier, as we now know, is definitely less than 1.

Here's the real bottom line that I wish taxpayers would understand: if the government hadn't borrowed and spent so much money, we would probably be enjoying a stronger, more normal recovery.

Not only has real GDP growth been miserably slow, so has nominal GDP growth. It's a weakening trend that has been in place for many years.

And as the chart above shows, inflation has been very low for many years. In short, there is no evidence here to support the notion that the Fed's "stimulus" has stimulated anything.

Bank reserves are important because in our fractional reserve system banks need to have reserves to collateralize their deposit base (about $1 of reserves for every $10 of deposits). Prior to 2008, reserves paid no interest, so holding reserves (which banks have to buy with real money) represented a deadweight loss. By limiting the amount of reserves available to the banking system (one of the main functions of the FOMC), the Fed could effectively control the degree to which banks could expand their lending. Since late 2008, however, that changed completely. The Fed now pays Interest on Reserves, currently 0.25%. That means that reserves are no longer a deadweight loss, they are much more like T-bills. They are a short-term, liquid, default-free, interest-paying asset. Banks now have an incentive to hold reserves, whereas before they had a disincentive to hold reserves.

Bank reserves are now an asset, just like loans are. Banks now weigh the relative advantages of holding reserves versus making loans. Given the risks of lending money in a weak economic environment, does the prevailing level of interest rates offer a significantly higher risk-adjusted return than holding reserves? If so, banks have the ability today to lend with virtually no limit, by using their existing reserves to collateralize new loans. That they haven't done so means that they find holding reserves (which is equivalent to lending money to the Fed) more attractive than making loans to the public.

As the first chart above shows, banks have been increasing their lending, but at a relatively slow pace in recent years. As the second chart shows, C&I Loans (bank lending to small and medium-sized businesses) have been growing much faster, but still they have not exceeded pre-recession levels. The facts say that banks have simply preferred to accumulate lots of reserves rather than make lots of new loans.

The above chart shows exactly how much banks have stockpiled in the form of reserves that are in excess of what they need to collateralize their deposits. It also makes it clear that QE2 and QE3 made relatively modest incremental changes to excess reserve balances. Tapering, when it begins, will hardly be noticeable on this chart. 

Of the $2.7 trillion of bank reserves that the Fed has created in the past five years, only about $75 billion have gone into the category of "required reserves," or reserves necessary to collateralize increased deposits. Around $365 billion have been converted into currency. (Note: increased bank lending does not mean that total reserves decline; it only means that some reserves formerly considered "excess" become "required.")

Tapering QE is only threatening to the extent it starves the banking system for high quality, short-term assets. As I've argued since October 2008, and more recently here, the main objective of QE was not to stimulate the economy, but to satisfy the world's huge demand for safe money in the wake of the disasters that unfolded in 2008. And that, in the end, is the big question: is the demand for more safe assets still strong? If it is, then tapering runs the risk of starving the banking system for liquidity. If not, if demand for reserves is beginning to decline because banks are becoming more confident in the health of the economy, then tapering is the right thing to do and it shouldn't be a problem at all, as I explain above. In my post last week, I argued that the demand for safe assets is beginning to decline, but it is still in its early stages.

Tapering is the first step on the road to an eventual tightening of monetary policy, which I define as a Fed-induced increase in real short-term interest rates. Once the Fed tapers its bond purchases (and no longer purchases any Treasuries or MBS), then the next step will be to begin to raise the amount of interest it pays on reserves (currently 0.25%). But it's a very long road we're looking at. The Fed won't be tightening monetary policy for a long time, not until the economy becomes noticeably stronger. It may take 6 months or so to end QE3, and then it might be another 6 months or so before short-term interest rates start to go up. It might take years before real interest rates become high enough to present a problem to the economy.

Be sure to read Calculated Risk's excerpts of Vice Chair Dudley's recent remarks. If it were up to him, there would need to be substantial improvement in the labor market before he would even consider tapering, and that could take 6-9 months if not more.

The chart above compares the real Fed funds rate (the difference between the Fed funds target rate and the year over year change in the PCE deflator) with recessions. Note that every recession since 1960 has been preceded by a marked tightening of monetary policy, in which the real Fed funds rate reaches or exceeds 3%. Currently, the real funds rate is -1%. Again, it will be a long time before monetary policy becomes tight enough to worry about.

Rather than fret about tapering, it makes more sense to worry about who the next Fed Chairman is going to be. Tapering is like easing up on the gas pedal, so that the car accelerates at a slower pace. The more important phase of monetary policy will be tightening, which is akin to stepping on the brakes. Janet Yellen—the current favorite to succeed Bernanke—has the reputation of being a "dove," which means that she would likely be less aggressive when it comes to tightening than others, since she firmly believes that monetary policy has the ability to "stimulate" the economy. This is a theory that is not shared by most monetarists and supply-siders, who believe that money growth that exceeds the demand for money only causes more inflation, not more real growth.

John Hilsenrath, writing in today's WSJ, says "Yellen Would Bring Tougher Tone to Fed," while also noting that she "has pushed the Fed to use low-interest-rate policies to spur faster economic growth and bring down unemployment." Yellen may thus be the first Fed Chair to practice "tough dove love," a new style of monetary policy that will undoubtedly raise the market's level of uncertainty.

In order to reverse QE, the Fed will need to a) shrink the supply of bank reserves by selling bonds and/or not reinvesting interest or principal payments, and b) raise the interest rate paid on reserves. These actions must offset banks' declining demand for reserves and make the interest rate they receive on reserves attractive, on a risk-adjusted basis, relative to what they think they can earn by increasing their lending activities. To do less would be equivalent to creating a surplus of money (via excessive bank lending) that would likely fuel higher inflation.

The next Fed Chair will almost surely oversee the Great Unwinding of Quantitative Easing. If not done correctly, we could find ourselves in a world of hurt. Yelled appears to lack the proper understanding of the limitations of monetary policy, and so the risk of a Yellen Fed is that monetary policy could become inflationary. But in any event, this is a risk that is still out there on the far horizon.

Would a Yellen appointment be a reason to buy gold? Not necessarily. I would argue that even with gold's recent decline from $1900 to $1300, it is still priced to a lot of inflation that has yet to happen. In real terms, golds is still trading significantly higher than its long-term average (see chart above).

Would a Yellen appointment be a reason to sell the dollar? Again, not necessarily. Although the dollar is up 7-10% from its all-time lows two years ago, it is still very weak from an historical perspective, which means that a lot of bad news is still priced in.

Would a Yellen appointment be a reason to sell Treasuries and MBS? Probably. As I pointed out last week, interest rates are still relatively low compared to current inflation.

How about stocks? I'll leave that for a subsequent post.

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