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!
Wednesday, September 24, 2008
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
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
Note: 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
Introduction
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.
Rod
Next Post: A Strong Form of Monetary Policy
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