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.

Stock Vigilantes to the Rescue

During President Clinton's terms of office we had the Bond Vigilantes. They rode herd on the government by raising interest rates whenever spending plans threatened to get out of hand. Today, with interest rates on U.S. Treasuries near record lows, the Bond Vigilantes have been overwhelmed by a desperate flight to safety by millions of frightened investors. But a new vigilante group has arisen to take over, the Stock Vigilantes.

For several weeks, it seemed that every time President Obama opened his mouth to explain a new, far-reaching government program he was planning, the stock market would take another 100 to 200 point dive. On the off days, Pelosi or Reid would add their thoughts and stocks would dive again. Then a strange thing happened. President Obama's poll numbers started first to fall, and then to plummet.

What we now have is a President frightened by his popularity dropping and realizing that millions of Americans, and not a few foreigners, are blaming his policy pronouncements for each additional 2, 3 or 4% daily drop in their retirement plans. That is, the Stock Vigilantes have taken control from the Bond Vigilantes.

It's no coincidence that President Obama recently decided he needed to hedge somewhat on the implementation of "Cap and Trade" legislation. Every time he raised the issue, the Stock Vigilantes took another chunk out of our retirement plans. When word surfaced that he was becoming ambivalent about pushing the most far-reaching restructuring of the American economy since FDR's New Deal, we finally had the best market rally of the year.

This President wants to take America down a far-left socialist road. Of that there can now be little doubt given his policy pronouncements since Inauguration Day. And it's unlikely that a drop in the polls will stop him. But Congress has another election day scheduled in a year and a half, and campaigning will begin soon. The Stock Vigilantes don't have the power to turn President Obama into a moderate, but they do have the power to scare moderate Democrats, and probably even a few liberal ones, into reining in the president's more radical aspirations, each of which promises to drive the American economy further southward.


Economic Forecast

As I said on December 2, the economy would hit bottom by March and certain leading numbers including retail sales and durable goods orders would rebound first. Employment would lag by a month or two, but would be the number that ultimately convinces the markets that the economy is turning upward. So far, both January and February's retail sales figures have come out stronger than expected. Though January's figure failed to ignite any enthusiasm, when the February decline of .1 percent (versus an expected decline of .5 percent) was reported along with a significant upward revision to January on March 12th, the market added to the rally it began on Monday, March 10th.

Durable goods orders, on the other hand, were still plummeting as of the January number, reported on February 26th. The February number to be reported near the end of March should begin to show a turnaround, however. The employment number remains dreary, and will not show strength until the numbers for March are reported in early April, or possibly even a month later. Nonetheless, the economy appears now to me to be turning on schedule, as I wrote in early December. Interestingly enough, a poll at CNN on when the economy would recover offered no option for "soon" or "now" and only 22% of respondents even chose the "later this year" option. The other 78% are looking for the recession to last until the end of this year at least.

The Bond Market

Rates plunged to absurdly low levels after my December 2nd forecast with the 10-year note yield falling to nearly 2 percent from the 2.70% rate in early December. That rate was unsustainable and 10-year rate is now back up near 3%, fluctuating between 2.75% and 3% lately. The long bond dropped from the early-December number of 3.25% to a low of near 2.5% in late December and is now back up, trading between 3.5% and 3.75% for the past month or so. As the signs of a strengthening economy mount, long term government securities are going to be slaughtered, especially given the massive borrowing that is going to be required to finance recent spending bills. And this is before inflation becomes a major concern, a factor that will likely come into play later in the year depending on Federal Reserve actions over the next several months.

The Stock Market

My December forecast on the stock market failed to account for the willingness of President Obama to destroy wealth by jettisoning the capitalist system, or at least expressing his intentions to do so, at the first opportunity. Otherwise, it's likely the lows made last November, which were then tested in January, would have held. Instead, investors lost all hope that the economy would be managed for growth and the market plumbed new lows. Only in the last week, when President Obama expressed a sentiment, and only a sentiment, that perhaps some of his ideas might have to wait for the economy to recover, did the stock market put in a convincing rally. However, this president has shown a remarkable ability to be able to say one thing while doing the opposite but not getting called to account for doing so. It remains to be seen what he actually does next, but my money would be on further attempts at wealth destruction. As I said at the outset of this piece, only the Stock Vigilantes are likely to be able to bring this process under control, and then only by scaring moderate Democrats facing re-election in 2010.

We should have seen a significant stock market rally by this point, and maybe we still will. However, this president and this Congress are not the investor's friends. Forecasting a bull market, however much the fundamentals will justify one (and they will) is a fool's game with the present crew in charge. At least that's how I see it.

The Housing Market

Face it, housing has been beat up beyond most people's (though not my own) expectations. While it might have further to drop, and while inventories remain plentiful, it's probably time to start picking and choosing if one is looking to get into a house near the bottom. Housing markets are local, and some markets no doubt still have much farther to fall, but in general if a potential buyer puts in exceptionally low bids on several houses over the next few months, and ends up buying one, I suspect he will be satisfied with his purchase a couple of years later. This will be particularly true if the Fed lets the recent monetary burst remain in the system.

The Federal Reserve and Money Supply

The massive injection of funds into the banking system in September of last year resulted in over a 50% growth in demand deposits over the four months through December (from $300 bn in August to $465 bn in December.) That injection is now being wisely withdrawn and the February number came in at $397 bn. If monetary policy is not to generate a 25% or so increase in the general price level over the next few years, the Fed must draw down demand deposits to close to the $300 bn level over the next few months. If they do this over the summer, a historically weak period for the stock market, the process could be hard on stock prices. Nevertheless, it must be done if inflation is to be held at bay.

As I said in early December, the massive reflation by the Fed could "turn on a dime" and so it did. Within a month they had taken action that significantly contracted demand deposits. As a reminder, for a reader to fully understand this process, you must read and understand the seven "priority" posts on this site.

Another Note to Business Leaders

I asked in December if it would be useful to know that the economy would be turning up by the second quarter of this year. You now have a huge advantage over market participants. This is because you can see your own sales trends and how your customers are acting. If the economy is indeed picking up, you will see it in your sales (unless, again, you build houses.) The problem is that given all the gloom and doom talk, including that coming from the White House, you might not believe what you're seeing. Let me tell you this. If your customers are starting to show signs of perking up, it's real. The time to batten down the hatches has passed. Don't sail into an economic recovery with a shrunken sales force and with your manufacturing operations unprepared to ramp up production, or you'll be caught unprepared yet again. Trust what you're seeing in your own operations, not what you're being told by outside economists because they will miss the turn by several months.

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?