Tuesday, December 2, 2008

Forecasting Markets and the Economy

This is the first post here concerned only with forecasting. As such, it is labeled "forecast" at the end of the post. If you're interested in the theory underlying the forecasts, read the seven initial posts labeled "priority."

NBER Declares a New Recession

Yesterday, the National Bureau of Economic Research stated that economic activity peaked in December of 2007 and that we then entered a recession. I refer readers back to the following statement on my post of October 10, 2008:

Note how the consumer expenditures in the GDP figures have started to be revised downward all the way back to the fourth quarter of 2007, revisions that are completely consistent with a monetary contraction beginning around the second quarter of 2007. Note also the reversal of the commodity bubbles around the world, the continuing fall in housing prices, and the steady rise in the stock market came to an end by the third quarter of 2007. All of this is consistent with a monetary contraction beginning in the second quarter of 2007, as explained in the monograph.

Finally, note the carnage in the stock market, the contraction of global credit and the sudden strengthening in the dollar over the past several weeks as the world's investors come to grips with the reality that we are deflating, rather than inflating.

While it was obvious that we were already in recession when I wrote the above in October, what was not obvious was that the recession started at the beginning of the year. In fact, there was very little talk of a recession until mid-year and even then the majority of forecasters seemed to be hoping that the travails of the housing market would be overcome by strong international activity.

The Proverbial Water Over the Dam

I bring up the past "forecast" (which I never made on a timely basis in a public forum and therefore it can hardly be called a forecast) merely to illustrate that the theory I set forth in the seven priority posts correctly fit the past activity. In that sense, it does little good. It is indeed water over the dam.

What should be learned by those of you reading these posts is that the bulk of public opinion during the past two years alleging that the Fed was being too easy was wrong. In fact, the Fed was being far too restrictive. Again, you really do need to read the monograph referred to in the earlier posts, and dissect those posts carefully if you are to understand the underlying mechanism that drives my conclusions.

Implications for the Future

What now? Given the massive injection of reserves into the system, many economists would naturally wonder whether the Fed has successfully eased. However, they remain concerned that the Fed is merely "pushing on a string" and that the injected reserves will remain unused. This is not the case, however, because demand deposits skyrocketed at an historic rate as soon as the reserve injection was initiated.

Under past operating procedures, this would always have happened due to the "hot potato" theory of monetary policy that I've explained in the monograph. Now, however, those operating procedures have changed and it becomes much more important to determine whether the Fed is indeed "pushing on a string." Right now, it appears they are not, because demand deposits have grown apace. They will bear close watching over the next several months though, to ensure that the present levels are sustained.

The Economy

With the demand deposit burst occurring in September of 2008, it is reasonably certain that the economy will begin to rebound soon and that by March of 2009 (exactly six months after the money burst) signs of that rebound will have become evident. These signs will include accelerating retail sales, durable goods orders and finally employment numbers. If the past is any guide, the first signs will be complete surprises to market participants, will temporarily move markets, but will then be overwhelmed by other (lagging) published information. Typically, the statistic that finally convinces the doubters, who will be legion to the very end, will be the employment number. Even then, it will take as long as two or even three quarters of recovery before the NBER declares the end of the recession.

The Bond Market

Again, if the past is any guide, interest rates will fall until the first signs of a recovery and then will begin a rapid rise that will be sustained for a long period. The caveat to this forecast is that interest rates, particularly on longer maturity treasuries, are already at ridiculously low levels that might not be sustainable for another three to four months. The carnage in the bond markets in the second quarter of 2009, if present rates hold until then, will be something to behold.

The Stock Market

I've found that the stock market reacts rapidly to a change in demand deposits, so by March of 2009 we will likely have experienced a significant recovery in stock prices. The Fed was executing an extremely tight, even deflationary, policy until the third week of September after which the sudden increase in demand deposits occurred in response to the massive injection of reserves. Unfortunately, by that time the stock market had already started its severe decline, a decline which essentially was wrung out by the second week of October. Presently the market is trying to put in a bottom around current levels, an effort that should prove successful.

The Housing Market

This is a market that got about 80-100% too high relative to general prices and it did so in a near-deflationary environment besides. The implications are that the rise was the result of a herd mentality (assisted by the nearly-insane lending standards fostered upon the industry by Congress--let's put the blame where it really belongs here) and that to reach equilibrium housing must fall, relative to other prices, by 40 to 50% over the next few years. In other words, no near-term recovery in housing is likely and, in fact, housing prospects are likely to continue to deteriorate. The only possible way to forestall this is to induce a sharp, sudden inflation.

The Inflation Picture

Which brings us to inflation. If the present burst in the money supply is sustained, then inflation will indeed reassert itself. However, since the Fed has effectively relinquished most of the power it once had over the level of the money supply with its recent (and accelerated) change in treatment of excess reserves (See the previous post for an explanation,) it is anything but clear what present policy will yield. If you understand the content of the priority posts on this website, they you will realize that just because the Fed tries to effect an easing in policy doesn't mean that they will be successful, even if it appears that they are. After all, Japanese authorities tried for years to ease following their real estate and stock market debacles of the 1980's and yet remained mired in a ten-year deflationary environment.

Right now, though, it would appear that the Fed is finally managing to reflate, and on a grand scale at that. This could turn on a dime, however, and bears watching.

A Word to Business Leaders

Would it have been useful to know in the fourth quarter of 2007 that the risks of an imminent recession had grown substantially? Look at your own forecasts at that time and decide. Now examine your present forecasts and ask yourself if it would be useful to learn that the economy will begin accelerating soon and that the recession should be behind us by the second quarter of 2009? I'm reasonably certain that this will be the case and that you should be making plans on that basis unless you are depending upon a recovery in the housing market as well.

You've got real money on the line, so if this economic forecast proves accurate, you might even want to consider adding me to your list of consultants. Have the ones you've been relying upon been doing all that well recently?

Sunday, November 16, 2008

Paying Banks to Hold Excess Reserves - Huge Mistake, Huge!

At the conclusion of the previous post I said that I would next explain how the Fed was getting ready to convert their control of monetary policy from what I claim is currently an "iron bar" to that limp "string" that many economists claim the Fed is always pushing on.

Fed Accelerates Plan to Pay Interest on Excess Reserves

In this press release, the Federal Reserve announced its intention to begin paying interest, for the first time ever, on excess reserves held by banks. One of the expressed reasons for doing so is cited at the end of the 7th paragraph: "Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector."

Unfortunately, it is that very opportunity cost that created the "iron bar" of monetary policy discussed in the previous post. As of October 1, 2008, that "iron bar" has been converted into a "limp string" and I fear the Federal Reserve has now lost control of monetary policy without even realizing they've done so.

Read the Monograph!

In nearly every post I refer to A Monograph on Monetary Policy, an unpublished paper that I wrote several years ago to explain how monetary policy has worked in this country for decades. If you've read it and actually understand it then you will also understand that it was the "opportunity cost of holding required reserves" that the Fed has just set out to "essentially eliminate" which gave the Fed tremendous power over the economy in the short run, and over inflation levels in the long run.

Now the Fed has relinquished a large part of that power. I say "a large part" because they still have a 75 basis point (0.75%) penalty rate that they impose, but that will likely not be enough to prevent banks from just holding onto excess reserves at the end of the two-week reserve calculation period. In the past, banks treated such reserves essentially as toxic waste and circulated them aggressively in an effort to drive their "opportunity cost" down to the minimum possible.

Again, as explained in the monograph, this "toxic waste" treatment resulted ultimately in the "iron bar." That is, even a modest provision of excess reserves would result in money growth. Conversely, a modest withdrawal of reserves, resulting in negative excess reserves would cause banks to have to scramble to find reserves, a process that resulted in an almost immediate contraction of the banking system as measured by demand deposit balances (with all the caveats discussed in the monograph applicable here.)

Japan, Again?

This country has been on a Japanese trajectory for over 20 years now. Japan had their stock market mania, then their real estate bust and then their lost decade, a decade when the Japanese monetary authorities could not get their money supply to expand. The reason for that failure was that they made the mistake of allowing the equivalent of their fed funds rate to go to nearly zero. This removed the "opportunity cost" that our own Fed is so concerned about, resulting in converting their iron bar of policy to the limp string so often discussed. The result was that for years they were indeed attempting to run the monetary policy of Japan by "pushing on a string."

This is why Bernanke was justified in being so concerned about deflation in the early part of this decade, a time when our Fed Funds rate was headed dangerously close to zero (though I doubt, given the recent decision, that he was concerned for the right reason.)

Now, we have doubled the reasons to be concerned. We are once again pushing the interest rate on federal funds to near zero, thereby risking the emulation of Japan's policy that created their "lost decade," and we have gone them one better by paying interest on excess reserve balances, thereby creating a situation where even at higher interest rates the Fed will have no power (or a much reduced power) to reverse a decline in the money supply.

What to Conclude?

Assuming the Fed has relinquished its power to easily and forcefully affect policy, in the sense that they could easily adjust reserves and thereby force money supply to increase or decrease accordingly (and quickly), force the economy to adjust accordingly (within a relatively short span of just six months) and force the inflation rate to adjust as well (over a much longer span of several years,) then we have entered, as they say, interesting times.

My advice, to myself as well as others, is to pay close attention to the level of demand deposits. They have ballooned since mid-September at an unprecedented rate. (Note that this process began several weeks before the Fed implemented the new policy of paying interest on excess reserve balances incidentally, indicating that the massive provision of excess reserves at that time had an immediate effect on the money supply.) Now, if the world works as laid out in the monograph, in almost exactly six months from mid-September, i.e., in about mid-March, the economic statistics will start looking up. Retail sales will have already rebounded, durable goods orders will also have begun turning up and the March (or possibly April) unemployment report will provide the final confirmation that the worst has passed. During that time, the stock market will have rebounded as well, greased by easy money and leading the economy, as usual, by several months. (A side forecast: When this happens, falling gasoline prices will get most of the credit.)

The Caveat

All of this is more or less baked in the pie already unless the Fed's new policy of paying interest on excess reserve balances results in their relinquishing control of monetary policy, as would be evidenced by a steady decline of the level of demand deposits over the next several months in spite of massive reserve provision by the Fed. The entire point of this post is that this might indeed happen. If it does, it would be nice if someone besides me actually understood why it was happening.

This concludes what I have to contribute to the theoretical discussion surrounding monetary policy and reserve management. I might add one further post that lays out what I believe a sensible reserve regulation regimen should look like, but if I never do that, simply going back to the 1950's policy would be an excellent beginning. This is not to say that we should run policy as we did in the 50's, 60's and 70's, because even then the Fed did not fully understand their potential power. But the 1950's reserve regulations gave them exactly the powers they need today, powers they have now all but relinquished.

Friday, October 10, 2008

The 2008 Federal Reserve Tightening

Throughout the first half of 2008 most market commentators declared that the Federal Reserve was in an easing posture. In fact, with fed funds at 2 percent, many declared that they were in the process of contributing to the next inflationary binge.

Fed Funds are a Poor Indicator of Ease or Tightening

It is misleading to use the federal funds rate to judge the degree of Fed ease or tightening, or even whether they are easing or tightening. Why? Because, as I explain in the monograph I keep referring to, while the market is watching the fed apparently ease by lowering the funds rate, the Fed in reality is sometimes managing to reduce the level of reserves in the banking system at the same time.

To understand this, to even believe that it's possible, you have to understand the Strong Form of Monetary Theory that I've discussed in previous posts, and in the monograph. As I've explained, one of the best (though still not even close to 100% reliable) indicators of the true Fed policy is the trend in demand deposits balances.

Demand Deposits in 2008

If you go to the Federal Reserve's H.6 Release for August 28, 2008 and scroll down to Table 3 titled Seasonally Adjusted Components of M1 you can view the level of demand deposits on a weekly basis (seasonally adjusted) for the past year and a half. Note that in April of 2007 demand deposits were at $305.9bn and that by May of 2008 they had fallen to only $288.4bn. This occurred while the Fed was supposedly easing.

Was this merely one of those times when banks were finding ways to utilize deposits more efficiently, so that the system wasn't really contracting? Well, look at Currency on the same chart. It peaked at $761.5bn in October of 2007 and then stopped growing, or even fell modestly, until April of 2008. This never happens. Currency always grows at a fairly steady rate due to the past increases in the general price level, i.e., due to the public's need to catch up with past inflation. So, yes, monetary policy was tight for the last half of 2007 and the first half of 2008.

Confirming Evidence of Monetary Tightness

Note how the consumer expenditures in the GDP figures have started to be revised downward all the way back to the fourth quarter of 2007, revisions that are completely consistent with a monetary contraction beginning around the second quarter of 2007. Note also the reversal of the commodity bubbles around the world, the continuing fall in housing prices, and the steady rise in the stock market came to an end by the third quarter of 2007. All of this is consistent with a monetary contraction beginning in the second quarter of 2007, as explained in the monograph.

Finally, note the carnage in the stock market, the contraction of global credit and the sudden strengthening in the dollar over the past several weeks as the world's investors come to grips with the reality that we are deflating, rather than inflating.

Finally, an Easing of Policy, and What an Easing!

Now look at the current Federal Reserve H.6 report. Note that Demand Deposits, seasonally adjusted, have exploded in September, reaching just over $400bn in the September 29th week, an increase over trend of more than $100bn!

It's not a String the Fed is Pushing On; It's an Iron Bar

Again, you need to read the monograph to understand this. In any case, if you go to this link to the Federal Reserve's current H.3 Release and look at the Excess Reserves column in Table 1, you will see that after running just below $2bn for the entire year, excess reserves have now exploded to nearly $70bn in late September and to $136Bn in early October! This is exactly what has caused the huge increase in demand deposits.

If ever there was an economic environment where the "pushing on a string" theory would seem applicable, this would certainly be it. Yet demand deposit growth, i.e., money supply growth, has ballooned at a rate never before seen (though we came close at the turn of the century and also after the 9/11 terrorist attack.) It's not a string, it's more of an iron bar.

The Implications for the Markets

Suddenly we have a banking system awash in demand deposits, housing prices have already adjusted downwards significantly, the gas price surge that caused U.S. consumers to reduce other spending has reversed dramatically and stocks are at values not seen since the 1980 bear market.

In the meantime, Treasury Bonds are near all-time low yields offering only security, but certainly not yield, and we are about to enter an inflationary era not seen since the 1970's if the Fed stays on this course.

But how can stocks rally when there are no buyers, you ask? Well, it will probably happen when people holding long-term treasury bonds come to the conclusion that they're now holding the riskiest asset in the game and try to shift some of their assets to the stock market. After all, stocks are a far better long-term investment in an inflationary environment that are long-term bonds.

Next, I'll discuss how our inept government is on the verge of converting the extremely useful "iron bar" to that limp "string" everyone is always talking about. Really. That's what's in the works, and it's important that we understand the implications.

Sunday, October 5, 2008

Monetary Policy, Pushing on a String - Not!

Two Schools of Thought about Monetary Policy Theory

How does the Federal Reserve influence interest rates, economic activity and the inflation rate? There are two schools of thought in this regard, one I call the weak form and the other I call the strong form of monetary policy theory. Note that I'm not addressing just monetary policy here, but the theory behind the policy.

The Weak Form

What I consider the weak form of monetary policy theory is the version where the chain of events goes thus:

1. The Fed eases by lowering the federal funds rate in the interbank market.

2. The lower fed funds rate causes other short-term rates to fall as well.

3. As the front end of the yield curve moves lower, businesses and individuals begin to take on more credit.

4. The increase in borrowing (and the associated increase in purchasing) generates an increase in economic activity.

5. Eventually, if rates are held too low for too long, the increase in economic activity generates inflationary pressures and pressure grows for the Fed to reverse course and begin raising the federal funds rate.

This is the way the world is viewed by most investors and commentators. The editorial page of the Wall Street Journal, for instance, espouses this theory. The weak form also leads to the old "pushing on a string" analogy of monetary policy. The assumption is that things can be so bad that the action of lowering interest rates does not induce any additional business activity (step 3, above) and so the economy remains stagnant. This belief also leads some economists to advise politicians that the only way to get things moving again is to spend some government money, i.e., to introduce some fiscal stimulus. Well, we tried that this year once already and it failed. Unfortunately, under the weak form of the theory our only available option is to do more fiscal stimulus. As before, it just won't work.

The Strong Form

Here, in what I call the strong form of monetary policy theory, is what I'm nearly certain actually occurs during an easing of policy.

1. The Fed, possibly inadvertently, adds sufficient excess reserves to the banking system to get reserves circulating furiously, driving down the federal funds rate at the end of the reserve calculation period. During this process, the average federal funds rate does not have to even be falling and might, in fact, even be rising.

2. If the Fed repeats this process for more than two reserve calculation periods, the excess fed funds being circulated in the banking system are forced into the money supply via other business and individual banking transactions. Again, this process might be planned by the Fed, or inadvertent. If inadvertent, the average fed funds rate is probably stable or even rising.

3. The pressure of the excessive money creation, if sustained for more than two reserve calculation periods, finds its way into the securities markets, particularly the stock market, causing an almost immediate rally in equity prices.

4. Once the increase in money supply has been generated the Fed institutionalizes it, probably inadvertently, by supplying the necessary reserves in future reserve calculation periods to support the now-higher money supply.

5. Along with the increase in securities prices, particularly stocks, other economic activity also begins to accelerate, but the lags are such that the reported increase in such activity only begins to appear approximately six months later.

6. Virtually all increases in the level of the money supply, properly defined, eventually cause a corresponding increase in the general level of prices, i.e., the inflation rate.

Now, under the strong form of the theory, increases in excess reserves, even though provided only intermittently and possibly even during a period of perceived tightening, generate increased money flows in the economy, reflected in immediate stock market improvement, an improvement in the economy reported with a six-month lag and an increase in the general price level that occurs, and is reported, over a period of several years.

Under the strong form, the Fed drives economic activity short term and tax policy and other government policies regarding regulation, etc., drive economic activity over the long term. Also, under the strong form, the level of interest rates is nearly irrelevant to the process, and fiscal stimulus is almost certainly counter-productive given that it sucks resources from the far more productive private sectors of the economy.

Read the Monograph to Better Understand How This Can Happen

As I explained in A Strong Form of Monetary Policy on September 20th, you should read A Monograph on Monetary Policy to better understand the complete picture of what I'm saying and to understand why I can assert the following:

It is possible, under the Strong Form of Monetary Policy Theory that I describe here, for the Federal Reserve to actually be tightening, i.e., causing reduced economic activity and lowering the overall price level, even though they are lowering the federal funds rate in the interbank market.

This can happen simply because the Fed can make, and does make, an occasional mistake in providing the necessary reserves to the banking system in any given reserve calculation period. That is, to take the current time frame, even though they have lowered the average funds rate over a period of months, they might have underestimated how many reserves were needed several times during those months.

Thus, even though the Fed intervenes in the market when the funds rate rises just a bit, thereby convincing the market participants that the Fed wants rates to be lower, they might inadvertently inject too few funds to satisfy reserve requirements for the entire reserve period. This mistake only shows up late in the reserve calculation period when individual banks realize they are short reserves and the calculation period is coming to a close. If this happens system wide, the scramble for the needed reserves results in a one-day escalation in the funds rate, sometimes a severe escalation. Yet, the next day begins a new calculation period and with the Fed again intervening at the expected low rate, everything settles back down.

The reason it takes several weeks for the pressures to escape into the other financial markets is that banks can carry forward a reserve deficit or surplus for one period, but not two periods. During the first period of tightness, the reserve desk managers hold off paying an excessive rate for fed funds because they can cover the shortage the following reserve period. However, they can't do this the second period and so the rate skyrockets as the system scrambles for fed funds that are not there in aggregate. All this while, the Fed, and most participants and observers, think the Fed is in an easing posture.

Has the Fed Really Been Easing in 2008?

I don't think so. In fact, I think 2008 could be characterized as a period of monetary tightening, under the strong form interpretation, a case that I will make in the next post.

Next Post: The 2008 Federal Reserve Tightening

Wednesday, September 24, 2008

Forecasting the Inflation Rate

For an extended period of time (from about 1948 to 1980) the management of the U.S. financial system stayed relatively constant in terms of innovation. By that I mean we didn't come up with concepts like NOW accounts during that period. Since then, of course, innovation and change have been rampant.

Effective Reserves Determined Inflation

During that thirty years or so, the Federal Reserve's operating system was stable enough that it became possible to pick out patterns. This is why there were so many monetarists in the late 70's, and so few today. The patterns have more or less been obliterated by the many changes made to the system since then.

One pattern was the six-month lag of overall economic activity to changes in Effective Reserves that I mentioned in the last post. Another was the overall level of prices relative to Effective Reserves. Note that I am talking about the "overall level of prices" here, and not just the inflation rate, i.e, not just the rate of change in overall prices.

Stated another way, if the level of Effective Reserves started at an indexed value of 100 in 1950 and moved to an index value of 150 over the next ten years, then the price level also tended to move upward by about 50% during a ten-year span, but lagging Effective Reserves by about three years.

A Great Example

In about 1972, President Nixon imposed wage-price controls on the U.S. economy. During the next several years, the inflation rate was muted regardless of the fact that Effective Reserve growth continued apace. By the time wage-price controls were removed, a significant gap had opened between the level of Effective Reserves and the level of the GNP Deflator. During the next several years, Effective Reserve growth was brought under control by the Volcker Fed, but the GNP Deflator began rising at a faster and faster rate.

This led to the double-digit inflation of the late 1970's, while the tighter reserve growth combined with that inflation to give us interest rates on U.S. Government Bonds that approached 15% for a time! What I was looking at was an Effective Reserve number that implied that inflation was rapidly coming under control, even though the reported inflation rate was in double digits. So I bought some 13.25% long treasury bonds, and at a modest discount to boot. As most of you no doubt realize, the inflation rate then began its long decline toward near zero a decade or so later.

One Tentative Conclusion

I watched the Effective Reserve number long enough, and the GNP Deflator's reaction to it, to form an opinion. My conclusion was that a given percentage increase in Effective Reserves resulted in a more or less identical increase in the GDP Deflator, though with a significant lag of several years. This bothered me some because it would seem that as the economy grew it would require a larger and larger level of money supply (and hence reserves) to support the higher level of economic activity. Then I realized that a case could be made that just as operating companies increase their productivity at an average rate of 2-4% annually, so might the banking system. In other words, each year they would make enough improvements in procedures (electronic checking, etc.) to enable the system to support the increase in overall economic activity without requiring added reserves for the banking system.

In the next few posts, I'll discuss how Effective Reserves are added to the system. It's not as clear cut as the textbooks imply.

Next Post: Monetary Policy, Pushing on a String - Not!

Tuesday, September 23, 2008

Currency is a Lagging Indicator

Various measures of money supply have been popular over the past four decades, but only two of them gained prominence in the stock market for any period of time, M1 and M2.

M2 - Milton Friedman's Favorite

The money measure designated M2 consists of currency in circulation, demand deposits at commercial banks and savings deposits at commercial banks. Over reasonably long time frames M2 did go up and down along with the economy and inflation. The problem with M2 is that the lead time was insufficient to use as an economic forecasting tool. Therefore, the markets never truly focussed on the M2 number when it was released.

The reason M2 has little forecasting value is that savings deposits are held at the discretion of the saver. If stocks were flying, people might cash in their savings and move into the market. The Fed could not force an increase in savings deposits, though if inflation rose for a sustained period of time, savings deposits would naturally increase.

M1 - The Market's Choice

In the 1980's the weekly release of the M1 number, which consisted of only currency in circulation and demand deposits at banks, was a big deal. If the number released on Thursday afternoon was larger or smaller than expected, the bond markets would react strongly, as would stocks when they opened for trading on Friday mornings.

And M1 did have some forecasting value. A sustained increase in M1 usually forced the Fed to react by either tightening further, or switching away from a previous period of easy money. If the increase in M1 went on too long, the economy usually rebounded, and if it persisted longer yet, inflation would start marching upward.

The Monetary Base - The Logician's Choice

The monetary base consisted of three factors, currency in circulation, total bank reserves, and an adjustment factor supplied by the Fed of St. Louis which accounted for the impact of previous changes in reserve requirements. The monetary base also had a good track record for anticipating future Fed moves, economic activity and the rate of inflation.

Effective Reserves - The Best of All

By the year 1976 I was convinced that the Monetary Base was the better measure of the three discussed above. Then one night it dawned on me that Currency (the cash in our pockets, in the cash registers, in the mattresses, etc.) should not be considered a leading indicator of anything. This is because we generally don't anticipate higher prices by carrying more currency. Instead, we react to past price increases by carrying more currency because we start running out of cash sooner than we used to. Why? Because prices have already risen! Currency, then, is a lagging indicator of inflation, and since inflation lags economic activity by a year or even two to three years, clearly currency did not belong in a forecasting measure.

Bear in mind that currency is a major component of both of the better monetary forecasting tools, the Monetary Base and M1.

So, I took the Monetary Base Series and subtracted currency out of it, leaving just the total reserves plus the adjustment factor, the combination of which I called Effective Reserves.

Effective Reserves - A Once-Great Forecasting Tool

When I plotted Effective Reserves versus three measures, the stock market, GDP (GNP at that time) and the inflation rate (in the form of the GNP Deflator) the strongest relationship I obtained was the one where Effective Reserves forecast the direction of GNP almost exactly six months in the future. For example, if the economy was doing fine, and then Effective Reserves slowed to zero or negative growth for an extend period, the reported economic statistics would start to flash recession almost exactly six months after the initial slowing of Effective Reserves. Similarly, if the economy was in recession, those same statistics would start to flash recovery almost exactly six months after Effective Reserves had bottomed out and started growing again.

Things Change - Unfortunately

Now, when I came up with all this I was the manager of the Bond Portfolio of the Tennessee Consolidated Retirement System so I had access to what most of the economists on Wall Street were saying about money supply measures, the economy and inflation. As I wrote in the Monograph, only one Wall Street economist appeared to be homing in on the concept and that was a couple of years after I initially formulated it. Then the rules changed drastically and NOW accounts were introduced. This, for reasons explained in the Monograph, changed the game completely and Effective Reserves could no longer logically be a useful forecasting tool, nor could M1, for that matter, as people were dumping demand accounts (which paid no interest) in favor of the new NOW accounts.

Demand Deposits - A Useful Present-Day Measure

Over time reserve requirements have been reduced so low (a mistake, in my view) that I no longer trust them as a forecasting measure. However, if M1 is adjusted by removing Currency, you get just Demand Deposits which still exist because businesses carry non-interest bearing deposits for cash settlement purposes. While I am certain that the old Effective Reserves measure was an excellent forecasting tool, there seems to be some value in Demand Deposits now that they've settled down again. (It took years for the shift from Demand Accounts to NOW Accounts to work their way through the system.) Simply put, if Demand Deposits peak and then start falling, we stand a reasonable chance of entering a recession about six months later. Similarly, if Demand Deposits have been growing strongly, no recession is indicated. However, this statement has to be severely tempered because the banks every now and again introduce a new mechanism that allows companies to utilize their cash balances more efficiently, e.g., sweep accounts.

The monograph explains in more detail the lag times involved, and I really suggest that one refer to it if these posts have piqued curiosity. Here's the link again: The Monograph on Monetary Policy

In the next post I'll discuss the relationship between Effective Reserves and the GNP Deflator that I observed in the 1950-1980 data.

Next Post: Forecasting the Inflation Rate

Sunday, September 21, 2008

Just How Strong?

Evidence I've observed over the years leads me to the conclusion that a change in the level of the money supply leads the stock market, the economy and the overall price level, but with different lag times.

Money and Stock Prices

An increase in the money supply results in an almost immediate increase in stock prices and a decrease results in an almost immediate decline, "immediate" being a matter of days to a week or so.

Money and Economic Activity

An increase in the money supply causes an increase in overall economic activity rather quickly, but it generally shows up in the relevant statistics, such as retail sales, durable goods orders, employment numbers and finally GDP, with a lag that is very close to six months, plus or minus a month, rarely two months.

Money and the Inflation Rate

Inflation lags money by years. A strong increase in the money supply might only begin to show in inflation numbers after two years or longer and the effect of the increased money supply will persist long after the money supply has been brought under control, again for two years or longer.

But what is money?

That's the rub. In the next post I'll explain why only two measures have worked over the years and the reasons neither can be trusted to be consistent. That does not mean, however, that the effect isn't present; only that we lack consistent measures from time to time. All of this is covered in the monograph I linked to yesterday, incidentally, and a great deal more.

Next Post: Currency is a Lagging Indicator

Saturday, September 20, 2008

A Strong Form of Monetary Policy

: To understand the organization of this website, read the very first post, Introducing OnTrack Economics, written earlier today.

Several years ago I wrote a paper on monetary policy, and its workings and impact on economic activity, the price level and investment markets, as I see it. I tried, without much success, to get various powers-that-be interested in my ideas. Fortunately, with the advent of the web, and particularly blogging, it is no longer necessary to go through the "powers-that-be" filter any longer.

My reading website, OnTrack Reading, gets several hundred visitors a day from people looking for information concerning reading instruction, word lists, teaching tips, etc. As those interested in investing, and economics generally, stumble across the information I intend to add to this website, I have little doubt that readership will grow because they will find much here that is both new and useful (in time.)

A Tutorial on Monetary Policy

I hold to a very strong form of Monetary Theory. By this I mean that I ascribe tremendous power to those who wield the monetary policy levers, perhaps even more than even the monetary authorities themselves feel they possess. I've thoroughly explained my thinking in A Monograph on Monetary Policy that you can download by clicking the link. As I explained in my very first posting, all PDF's are stored at my other website, so you will be asked whether you want to open the PDF from ontrackreading.com.

The monograph is quite long, but you will find it particularly applicable in the present environment where the Fed Funds rate again is threatening to plunge to nearly zero if economic conditions continue to deteriorate.

An Invitation for Comments

If I begin to receive comments and questions on the monograph, I will devote several posts to addressing them, so feel free to have at it. I've enabled comments on all posts for now until I see how bad the spammers get. I finally had to disable comments on my other site, but it's a more formal site than this, so hopefully it will be possible to have a thorough exchange of ideas here without much hassle.

Has the Fed Really Been Tightening?

In any case, over the next few days I'll discuss various aspects of the theory set forth in the monograph so that readers can discern the relevance to today's economic situation. However, if you read it before then, perhaps you will understand how it is that the Fed has not actually been easing as they have lowered the funds rate back to 2%. To the contrary, it's probable that they've been inadvertently tightening instead.

Next Post: Just How Strong?

Introducing OnTrack Economics


My primary website is intended to help parents and teachers when dealing with dyslexic children, or with children struggling to learn to read. That website is OnTrack Reading in case you're curious. If you have such a child , or are dyslexic yourself, you should consider visiting that site.

However my other active interest is investing, and particularly the workings of monetary policy as it applies to economic activity and investing. So, I decided to start this blog, OnTrack Economics, to give me a place to explain what I've learned over thirty years of following monetary policy, economics and the investment world.

Just as OnTrack Reading has become a repository of much that I've learned over the past ten years about teaching reading, I have hopes that this site will become a repository for theories I've developed over thirty years regarding monetary policy and its impact on the U.S. economy and its markets. I am reasonably confident that readers with an interest in economics and investing will find what I write here to be useful.

Unfortunately this blog setup doesn't appear to allow the placement of permanent content in a segregated area on the blog. For that reason, I will try to use the LABEL section to identify various posts, as follows:

Meaning of Label Titles

Essential: Posts labeled "Essential" will contain information that I consider essential reading if you are to understand how this blog is organized. They should all be read to get the full use of this site.

Priority: Posts labeled "Priority" will contain what I consider ideas that have permanent application. They should be read in sequence from oldest to newest to gain a complete understanding of my views on monetary policy and economic consequences of that policy.

Other labels will possibly be incorporated as this blog develops, or I might try a different way of organizing the permanent content. I'm hoping that by using the label function in this manner I can offer readers a way to browse through the content they desire to read without having to read page after page of blog posts.

Use of PDF Files

Occasionally I will link to a PDF file containing a more formal write-up of my thinking in certain areas, or possibly to various communications I've had with various financial publications, etc. Because this site does not allow the uploading of PDF's, I will upload them to my other website at ontrackreading.com and link to them from here. This is why you will see ontrackreading.com as the source of the PDF when you are asked whether you want to open the file.

A Word of Warning

If you've read this far, you've no doubt noticed that I get pretty wordy. That isn't likely to change.

I look forward to an exchange of ideas.


Next Post: A Strong Form of Monetary Policy