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.

Has the Federal Reserve Made Itself Irrelevant?

The previous Monetary Policy posts explained why the Fed has essentially lost control of the money supply. By "lost control," I don't mean that it's out of control to the upside, but that the Fed simply doesn't control the level of the money supply any longer due to the operational changes they've made since the 2008 financial panic.

How Does the Fed Control Money? Their Answer

The Fed has always operated as though they controlled the money supply and ultimately the price level, i.e., the rate of inflation, by manipulating short term interest rates. If the short term rate was too low, people borrowed more, the economy grew faster, and the money supply and possibly the inflation rate would increase in response. To slow the process, the Fed would raise rates.

Today, under their own view of how monetary policy operates, clearly the Fed has to a considerable extent lost its power to influence economic growth. The short-term rate is essentially zero and has been for years now, but the economy continues along a slow growth path with low inflation. And even to achieve that, the Fed had to augment its normal operating procedures with the QE's.

As some are now beginning wonder, what would the Fed do if the economy slowed today?  With short rates nearly zero, driving them a bit lower is unlikely to change anything. More Quantitative Easing, perhaps? Negative interest rates for savers? Or just admit that the current operating procedures don't work because, clearly, they don't.

How Does the Fed Control Money? The OnTrack Economics Answer

The previous posts on monetary policy described a "strong form" of monetary policy by which the Fed has direct control over the level of the money supply. Following an injection of excess reserves, money grows. Then the economy responds and eventually the price level (inflation) responds. Similarly, withdrawing reserves shrinks money, causes the economy to contract, and puts downward pressure on the inflation rate. This is a model that can be shown to have worked in the past. Furthermore, it's the most obvious operating procedure to deploy in a system of fractional reserves, but one the Fed has apparently never consciously adopted.

Unfortunately, because the Fed chose to implement the QE strategy, it now finds itself in a position where it will be extremely costly (to the Fed itself and, by extension, to the taxpayers) to adopt the approach indicated by the strong form of monetary policy. An earlier post explains how the Fed is now exposed to losses of both portfolio value and annual income on the order of hundreds of billions of dollars should it attempt to return to a time when the level of excess reserves in the banking system averaged just a few hundred million dollars, as would be required to implement the strong form.

The Obvious Conclusion: The Fed Is Now Irrelevant to its Purpose

Sure, the Fed can still cause all sorts of economic mischief. It can leave rates low, penalizing savers, pumping asset markets, and protecting the most massive positive carry trade of all time (on its own books), or it can seek to drive them into negative territory by issuing regulations that deter large banks from taking on additional deposits. Alternatively, it can start raising rates, but to what purpose? The increases it suggests it will take are extremely modest and will have little effect on either the economy or the inflation rate, so why bother, except perhaps to reduce political pressure from savers incensed by ridiculously low interest rates?

Meanwhile, as a testament to the Fed's current irrelevance, the money supply, the economy, and prices, will fluctuate unimpeded by anything the Fed does. The $2.5 trillion of excess reserves in the banking system assures that. If the economy starts to heat up, the reserves are there to permit a rapid expansion of the money supply, an expansion that the Fed will be unable to halt without neutralizing the entire balance of excess reserves. Until those reserves are somehow neutralized the money supply can grow unimpeded, without any sort of a governor to keep it in check. That doesn't mean it will, but it can, and it might.

And if the economy starts to once again contract, they're out of ammunition. The banking system could contract and nothing is in place to halt the contraction because the Fed has rendered the level of excess reserves irrelevant. Ironically, in doing so, the Fed unwittingly made itself irrelevant as well, as we are now seeing.

Perhaps it's finally time to bring this grand, failed, financial experiment to an end and rewrite the Fed's mandate?

Positive-Carry Trades Often End Badly

A positive carry trade in the bond market is relatively easy to understand. Usually longer maturities yield more than shorter maturities, and weaker credits yield more than stronger ones. Buying a long bond and financing it by borrowing in the short term market thus yields a positive earnings spread each day the trade is on the books. Any decline in the price of the long bond must, of course, be deducted from that positive spread to evaluate the profitability of the carry trade.

How Carry Trades Start, and Tend to Build

When the Fed is perceived to be in an easing stance bond traders tend to start carrying more long bond inventory, financing that inventory in the overnight repo market. Both sides of the trade stand to make money, with the financing cost dropping the longer the Fed eases, and with the price of the long bond generally rising over time in response to the easing.

As profitability in the original trade grows, more risk tends to be taken. That is, the carry trade position tends to increase in magnitude. More bonds are bought, at successively higher prices, the price continues to rise, financing costs continue to fall, etc.

How Carry Trades Tend to End

As with any successful investment (to that point), the first entrants tend to do the best, often because they are just better at assessing trends and risks, but sometimes because they just got lucky. In time, the success of the carry trade draws more and more participants, the result being that the bond market gets overloaded with traders all on the same side of a trade, long bonds being financed short.

The ending is often brutal, with an unexpected Fed tightening or, more likely, an unexpected Fed announcement of an impending policy reversal, causing a fall in bond prices. Those last into the trade, already underwater immediately due to the drop in the asset they hold and faced with an impending increase in financing costs to boot, begin to exit the trade. Others try to follow and some even try to set short positions.

The net result is that those who entered the trade late suffer losses that can be significant, but those who entered early end up quite satisfied with the net result. Carry trades are very popular because, all things equal, they make income with each passing day. Plus, markets, particularly short term markets, tend to trend due to the influence of Fed policy (which always trends.)

The Federal Reserve's Perfect Carry Trade, Established by Law

Until recently the fed enjoyed the perfect carry trade, an unending guaranteed profit established by law.

Every dollar bill and piece of change held by individuals, businesses, and foreigners was first issued by the Fed to a bank in the banking system in exchange for an equal amount of that bank's reserves held at the Fed. That is, the banks traded bank reserve balances for actual currency. Since currency in the vault counts toward meeting reserve requirements, the bank was unaffected.

Not so with the Fed, however. The Fed issues a nearly costless piece of paper to the bank, a piece of paper that represents a liability to the Fed (which is why they all say Federal Reserve Note on them). Offsetting that liability is an asset portfolio that typically was composed of short term maturities like U.S. T-Bills. Similarly, in the past the reserves that banks were required to hold at the Fed were costless, in that until recently the Fed paid no interest on those reserves.

Thus, virtually all of the Fed's liabilities were costless and all of their assets earned the short-term rate available at the time. The perfect carry trade, always profitable, persisting forever, and even growing steadily as the economy and associated money supply expanded over time.

The carry trade was exactly the reason that the Federal Reserve, even after paying all of its operating costs, could remit a significant profit to the U.S. Treasury (and thereby to the taxpayers) each year. One is even tempted to wonder whether the excessive money growth that has been a constant feature of monetary policy ever since the Fed's inception might be due to the carry trade doing better the more the money supply grew.

The Largest, Highest-Risk, Carry Trade of All Time

Over the past several years the Fed has:

1. Decided to pay interest on reserves, thereby exposing the financing side of its carry trade to a new financing risk.

2. Decided to shift its portfolio massively to the long end, thereby exposing said portfolio to the risk of future market fluctuations in bond prices.

3. Decided to increase its portfolio to around $4.5 trillion from a bit under $1 trillion a few years ago.

In other words, should interest rates now rise the Fed will see it's financing costs rise, its portfolio likely fall in value, perhaps significantly, and will be subject to losing on both ends of a $4.5 trillion portfolio.

Conclusions

When a federal agency under the direct control of Congress takes it upon itself to turn a sure annual gain for the taxpayer into a highly risky gamble for said taxpayer without first taking it to Congress for discussion and approval, but just goes ahead and does it on its own, it's time for Congress to intervene. Here are three suggested questions at any future hearing:

1. How much price risk does the Fed portfolio have under various assumptions of rising rates?

2. How much of an income hit will the Fed take under various assumptions of rising rates?

3. Do these risks in any way compromise the Fed's decision-making process, especially when considering whether to raise the short term rate of interest?

Now, admittedly, the Fed has earned a lot of money over the past several years while carrying this trade and that should be taken into account. However, they've also completely overwhelmed the Treasury's decision to extend the maturity of the debt at historically low interest rates, a fact that will be made clear should interest rates ever rise to the point that the Fed runs at an annual deficit and has to go to Congress for its funding, rather than remitting funds annually as it has typically done.

For some concept of the likely outcome in a rising rate environment see the post that started this recent series of posts here at OnTrack Economics: The Fed's Massive Conflict of Interest.