Japanese Monetary Policy in the United States

An Old Forecast Appears to be Coming True, Unfortunately

In December of 2001 I wrote and published (on an older website) a monograph that I titled "A Strong Form of Monetary Theory based upon Excess Reserves and Bank Demand Deposits."  (The pdf is still stored on the original site which is actually a reasonably popular site that I created to explain a phonics method that I devised.)

My intent at the time was to explain a theory of fractional banking that I believe actually worked, but one that had eluded the Federal Reserve even as they enjoyed its benefits. However, as I've re-explained in six recent posts here, starting with the post titled Monetary Policy Theory: Part 1 - Fractional Reserves, the Fed has drifted a long ways from the system it operated in the 50's, 60's, and 70's, and it will now be difficult to return to the environment in which the theory I espouse can be operational.

The Forecast, or at Least, The Foreshadowing

In the monograph cited above, on page 8, I wrote in December of 2001 the following regarding Japan's decade-long stagnation with near-zero interest rates at that time:

Where next? Japan and America 

Japan should stand as fair warning to America that the economics of banking is an imperfect science. Thus far, no one has adequately explained to the powers-that-be either a reason why they are in a sustained period of recession, or a reasonable way off that path. Yes, theories abound, but either they are so imperfect that they are not taken seriously, or they have been implemented and found wanting.

There is no reason that we must follow Japan’s path. However, there is also no good reason why we will not. Under current economic theory, we are doing what we must to avoid it, but we are also doing the same thing that Japan did (in monetary terms) and simply expecting different results. If Japan’s economic recessions are being caused by monetary events, as I believe is likely, we might think twice before conducting an imitation of their recent policy, as we now appear to be doing.

Today, as 2015 draws to a close, with the Fed now growing increasingly concerned that the economy, or at least the global economy, could be slowing, and with the fed funds rate still at only 25 basis points, we are now in Japan's situation, unfortunately.

Conclusion

The Strong Form of Monetary Theory that I present in the monograph enabled me to write the above two paragraphs back in 2001 with some degree of confidence because under that theory the central bank loses control both of the money supply and, therefore, of the economy, at zero interest rates.

But it's also important to realize that this isn't the typical "zero-lower-bound" problem popular with so many, a theory that declares that if the market economy drives short term interest rates to zero, the central bank might lose its ability to conduct effective policy. No, instead, under the strong form, this was simply a mistake made by the central bank, a correctible mistake.

All the Fed has to do is raise the fed funds rate to a modest positive level, say 1.5% to 2% and they will again regain control, and the Fed is perfectly capable of doing so; it just doesn't understand the reasons why it should be done. The answers are in both the monograph and the six recent posts here on monetary policy.

What Will a Fed Tightening Look Like?

The Federal Reserve has created quite a situation for itself with the three bouts of Quantitative Easing (the QE's). They appear to be considering raising the fed funds rate at the September meeting, but the rout of stock markets worldwide has many now arguing that the action should be postponed, on the assumption that an apparent tightening of policy would only make things worse.

Ironically, even those who've long been calling for a return to "normal" short rates are now becoming a bit reluctant to see it happen, for fear that both the economy and markets are on the verge of going south and that their longstanding advice will get the blame if the market declines continue.

How Would the Fed Tighten?

This isn't a question with a simple answer. It used to be, but no longer. In the "old days" prior to implementation of the QE's all the Fed would do is intervene directly in the fed funds market by selling some of its securities to the banking system. It would do so when funds were trading at, say, 3%, thereby signaling that 3% (or something higher) was the new floor to the fed funds rate. The funds market would adjust to that signal immediately and begin to trade in a higher range. Should it drop to 3% again, the Fed would simply sell more securities.

However, this only worked because banks needed to hold a specific level of bank reserves to meet their reserve requirements and because there were never more than a few hundred million dollars worth of excess reserves in the system. Thus, by draining only that few hundred million, the Fed could ensure that funds traders would be scrambling to meet their reserve obligations by the end of the reserve week, bidding up the fed funds rate in the bargain.

Now, however, with $2.5 trillion of excess reserves in the system, the Fed can't raise the fed funds rate with a simple draining operation as they used to be able to do. Say they try to signal a move to a 0.5% funds rate by selling a billion dollars worth of their portfolio thereby draining a billion dollars from the banking system. Would it matter? Not at all. The banks would still be sitting on almost $2.5 trillion in excess reserves, on which the Fed currently pays them interest at a .25% rate. If the Fed tries to get fed funds to trade at 1/2% the banks will hit any bid over 1/4% because that would be a better rate than what they're currently earning on their excess reserves at the Fed. With $2.5 trillion available for hitting the bid, the banks will win that battle and funds will not trade above 0.25%.

So, What's the Answer?

Clearly, the Fed has to somehow neutralize the $2.5 trillion in excess reserves if they're to effect a tightening in the form of raising the fed funds rate. They have two obvious ways to do this. The Fed can either sell enough securities to directly drain the entire amount, or they can offer to pay the banks a higher interest rate on their excess reserve position. Since selling $2.5 trillion worth of long maturity debt into what would surely be a deteriorating market would be highly impractical, over the short term at least, it's obvious that the Fed will instead raise the rate they pay on reserves, probably to the upper end of the new target range, since it will become a ceiling for the funds rate, as outlined above.

Thus, rather than the market being clued to an eventual tightening by a Fed open market operation, as in the not-all-that-distant past, instead the Fed will just announce that it's raising the interest rate it's paying on reserves. That will be the tightening. It will be a simple announcement, rather than an open market operation.

Some Implications of Raising the Interest Rate Paid on Reserves

Those of you who've read the earlier posts here will be aware that I think that paying interest on reserves, and particularly on excess reserves, was a huge mistake. That said, such interest is now being paid and that has several implications.

First, as described above, a tightening will now very likely take the form of an announcement that the Fed is raising the interest paid on reserves. Now, the vast majority of the public, and this includes a reasonably large majority of investors I suspect, will have no idea what that announcement means. It could actually be phrased in such a way as to sound quite innocuous, as in, "The Fed is announcing that the rate it will pay on reserves held by the banking system will be increased to 1/2 percent as of today." Accompany that with some gibberish about maintaining the health of the banking system and an added note that it's leaving the discount rate unchanged, and many investors might not even realize it's a tightening until it's explained to them later. Meanwhile, the fed funds rate might even continue to trade well under 0.5% for a bit, further confusing the matter.

Second, if you've read the post preceding this one covering the massive increase in demand deposits in the banking system, you might realize by now that the only reason for the increased level is the existence of the ZIRP (Zero Interest Rate Policy). If ZIRP disappears, then so does the rationale for the massive increase in demand deposits. That means that as the Fed gradually raises short term interest rates the level of demand deposits in the banking system will plummet.

Finally, and again drawing on the previous post, whereas I believe the dramatic falloff in the growth of demand deposits in the banking system since February of this year could well indicate that the economy is either already in, or is soon entering, a recession, the plummeting demand deposit balances that will occur when the Fed raises rates will not carry the same meaning. Instead, it will simply mean that the level of demand deposits will be returning to what it would have been had ZIRP not made people indifferent between short-term savings account and checking accounts. That is, once they can earn interest on their savings accounts again, they will begin again to minimize their demand balances.

But, because the Fed most likely doesn't agree with the analysis here, there's a significant danger that it will misinterpret a sharp drop in the level of demand deposits and somehow seek to counteract it. I doubt they'll be able to stop demand deposits from falling, but should they manage to find a way they could indeed open the doors to a significant rise in the inflation rate.

Conclusions

Thus, if a tightening is to occur, it's likely to take the form of an announcement that the Fed will be paying a modestly higher rate on bank reserve positions. That rate is currently 1/4%. From all indications, it will probably be raised to 0.5% if the Fed goes through with a tightening.

They will also probably begin to intervene in the fed funds market entering sooner to do reverse repurchase agreements with quasi-bank entities at a somewhat higher rate. Currently those funds trade between zero and 0.25%. This is a fairly technical issue, but it could confuse people because fed funds will often trade well below 0.5% at times. It involves the repurchase facility the Fed recently established to do business with entities that don't have direct access to the banking system's fed funds market.

One final note, from the perspective of a proponent of the strong form of monetary policy: This wouldn't really constitute a tightening at all. It would just be the beginning of a restoration of normalcy to the banking system, a restoration that will be necessary if the Fed is to ever again be able to utilize its normal operating tools, that is, those used for decades prior to the implementation of the QE's.

By the way, that meager 1/4 percent increase in the rate the Fed would be paying on reserves will cost them over $6 billion in additional interest payments per year, a tidy sum that might explain why all of this has taken so long to materialize (as suggested in The Fed's Massive Conflict of Interest.)

Is the U.S. Economy in Recession?

In this post I'd like to briefly discuss what the Fed's ZIRP (Zero Interest Rate Policy) has done to corrupt the money numbers and then explain why, in spite of the difficulty of analyzing corrupted numbers, the United States is probably already in a recession, one that started in the 2nd quarter of this year and continues today.

Explaining the Excessive Growth in Currency in Circulation

Anyone who has read the Strong Form of Monetary Policy that I've described in earlier posts might be wondering why currency growth has not reflected the inflation rate recently. Currency growth the past five years has been on the order of 8% per year whereas per the government inflation has been running at less than 2%.

Because a lot of U.S. currency goes overseas, especially in times of international turmoil, some of the excess growth could be explained in that manner. However, ZIRP is also likely to be partly the cause, although not to the extent that it has influenced growth in demand deposits (as will be explained next). When there is no effective cost to carrying cash, people are likely to be indifferent as to the whether to carry an excess of it, for they're not earning anything on the alternatives to cash, including their NOW accounts. Businesses, in particular, would be less sensitive to having well-stocked cash registers.

Yet, most people won't arbitrarily decide to carry wads of cash around just because it's costless, for the simple reason that they might lose it, or have it stolen. That, of course, includes businesses. Then, of course, there's yet another explanation: Perhaps the government inflation numbers are understated, as some fairly reputable sources do, in fact, claim, and that inflation is really running 4 to 5% instead?

Explaining the Excessive Growth in Demand Deposits

This one is far easier. Shorter term savings accounts are earning so little in interest that people are very likely to carry far larger balances in checking accounts today without worrying about the opportunity cost. When $10,000 is likely to earn less than a dollar in a money market fund over a year, why bother? The result has been that demand deposit growth averaged around over 21% per year over the five years ending in February 2015 versus NOW account growth over that time of less than 6%.

When there's no opportunity cost (in the form of lost interest) to holding cash or demand deposits, people, and businesses, simply hold more cash.

Why No One Pays Attention to the Money Numbers Anymore

The favored number of the ancient monetarists (way back in 1979) was M1, which consisted then primarily of currency in circulation plus demand deposits. Five years ago, in February of 2010, M1 was $1,715 billion. This year's February number was $2,995 billion, up at an annual rate of 11.8% over the five years. Monetarists of the past would be expecting a massive inflation rate to have resulted by now.

Very few monetarists at the time focused just on the demand deposit component, but it has gone in the same five years from $458 billion to $1,277 billion, for a 21.6% annualized rate of increase. Note that it has also become a far larger component of M1 in the doing. Under the strong form of monetary policy that I espouse, inflation would be raging by now if that sort of increase had occurred with interest rates not so close to zero percent.

Obviously, then, the money numbers have contained nothing but misleading information since ZIRP became the order of the day. And, in truth, they've contained little information since 1980 when NOW accounts were introduced, as explained in earlier posts.

Finally, Why Might the U.S. Already be in Recession?

While the above discussion explains why neither M1 nor its demand deposit component should contain much guidance for future inflation, that doesn't mean that demand deposits aren't useful for determining whether or not a recession is looming.

Here are the interesting numbers: $1217, $1202, $1204, $1193, $1206. Those are the demand deposit totals, in billions, for February, March, April, May, and June of this year. And the first four weeks of July only averaged $1217 as well, before a huge burst in the last four days of July that brought the total for July to $1,227 billion. Note the virtually zero growth from February to late July following a five year run of growth in excess of 20%.

As explained in earlier posts, while I no longer believe the Fed is capable, under its current operation procedures, of causing such a contraction in the growth rate of demand deposits, that doesn't mean that the contraction itself has no forecasting power.

Indeed, it seems highly unlikely that the virtual cessation in the steady 20%+ growth of demand deposits over the five years since February of 2010 means nothing at all. To the contrary, one needs to ask if the almost five month period of virtually zero growth in demand deposits is a reflection of something, perhaps an economic contraction that has been underway for several months now?

Under the old monetary regime of the 1960's and 70's, such a cessation of demand deposit growth was usually a precursor of an impending recession, particularly if it persisted for six months or so. Back then, however, the Federal Reserve was usually the direct cause of the slowing growth of demand deposits, something that's unlikely today.

Conclusion: Be Careful of the Second Quarter GDP Revisions

On July 30th the government announced that GDP grew at a 2.3% annualized rate, or about 0.6% for the quarter alone. In three days, on August 27th, the first revision will be announced. Don't be surprised if it's a downward revision, perhaps not to negative territory, but downward. By the second or third revision, it could well be a negative number. And, whether or not the 2nd Quarter number is revised downward, the 3rd Quarter GDP number could very well come in at an outright negative number if the sharp falloff of demand deposit growth holds meaning.

So far, the only suggestive evidence of weakness, besides a long topping formation in the stock market that began, perhaps not coincidentally(?), in late February, is a small drop in the last Leading Indicator number and relatively weak retail sales figures for the past few months. If we are in a recession, the news generally lags the event itself and upcoming announcements will confirm it.

Note, by the way, that the Federal Reserve had precious little to do with initiating any recession that might result, and that it also will have precious little to do with ending it, having boxed itself in from a policy perspective as explained in a recent post.