The $1 trillion tax on cash

One under-appreciated side-effect of the Fed's quantitative easing and zero-bound interest rate policies is the sizable "inflation tax" borne by all those who have been holding cash, cash equivalents, and short-term securities since the end of 2008. By my estimates, this tax could total $1 trillion or more. As the public becomes increasingly aware of this under-the-radar tax, the demand for cash and short-term securities (cash equivalents) is likely to decline, and that will complicate the Fed's QE exit strategy.

The Fed's target for the fed funds rate (the rate banks charge each other to borrow bank reserves) sets the tone for all short-term interest rates. Since late 2008, the nominal target for the the overnight Fed funds rate has been 0.25%, and the Fed has been paying 0.25% on bank reserve balances held at the Fed. As the graph above shows, this extremely low level of short-term rates is unprecedented in modern times. For their part, banks, which have invested essentially all of their savings deposit inflows since 2008 in bank reserves, have paid very low rates to the holders of savings deposits: 1-mo. Libor has averaged 0.24% since the end of 2008 and is currently a mere 0.16%, and most banks and money market funds now pay between 0 and  0.15% on short-term savings deposits. Obviously, banks need to pay less on their deposits than they earn on their assets (e.g., bank reserves). Taking fees into account, the effective nominal interest rate on most savings deposits today is zero or even slightly negative.

The extremely depressed level of nominal interest rates since late 2008 has been exacerbated by the fact that inflation has averaged about 1.5% per year, according to the Core Personal Consumption Deflator, the Fed's preferred inflation measure (see graph above). 

The combination of very low short-term interest rates and 1.5% inflation has resulted in 5 ½ years of negative real short-term interest rates. As the graph above shows, this is the longest and most significant period of negative real interest rates in over 50 years. Recall that the negative real interest rates of the late 1970s occurred during a time of sharply rising inflation.

Negative inflation-adjusted short-term interest rates affect a lot of people and a lot of money. Anyone holding cash and cash equivalents (e.g., currency, checking accounts, savings deposits, money market funds—the things that comprise the M2 measure of the money supply, arguably the best measure of the public's store of readily-spendable cash) during this period has suffered a significant loss of his or her purchasing power—on the order of 7% or so. Bank savings deposits now represent about 65% of M2, while checking accounts ($1.6 trillion) and currency ($1.2 trillion), represent another 25%.

By the end of this year, when interest rates are almost certainly going to remain very close to zero, the cumulative loss of purchasing power suffered by those holding cash and cash equivalents (as proxied by the M2 measure of money and using the real Federal funds rate as a proxy for the real yield on M2) will be, by my estimates, at least $700 billion.

Using M2 as a proxy for cash and cash equivalents gives a lowball estimate of the inflation tax, however, since it does not include the purchasing power lost by those who held short-term notes yielding less than 1.5% (i.e., less than the annualized inflation rate) since late 2008. That would include any Treasury securities with less than 5 years' maturity, since the yield on 5-yr Treasuries has averaged 1.5% over this period. (For example, 2-yr Treasury note yields have averaged 0.5%, so those who held 2-yr Treasuries have suffered a -1% annual real rate of return. For holders of T-bills it's even worse, since the average nominal yield on 3-mo. T-bills since late 2008 has been a mere 0.08%.) It also doesn't include the inflation tax effectively paid by holders of institutional money market funds, commercial paper, and bank CDs not included in M2. So the total inflation tax on cash and short-term financial instruments is probably well in excess of $1 trillion.

The "inflation tax" I'm referring to is the loss of purchasing power that results from holding a monetary instrument with a yield less than the inflation rate. The holder suffers a loss of purchasing power, while the issuer—in most cases the U.S. government and the Federal Reserve, for whom money, bank reserves T-bills, and short-term notes are a liability—benefits because their liabilities can be repaid with cheaper dollars. In other words, the purchasing power you lose every day as a result of holding cash, cash equivalents or short-term securities is equal to the amount the federal government and the Fed benefit. The inflation tax is a direct, and largely underappreciated transfer of wealth from the private to the public sector. And it's big.

The M2 measure of money supply has been growing at about a 6.4% annualized rate for over 7 years. This growth is very much in line with the past history of M2, which has grown at an annualized growth rate of 6.4% over the past 15 years and 6.1% over the past 20 years. The lion's share of M2 growth in recent years has come from bank savings deposits, shown in the graph above. This isn't money that the Fed has "pumped" or "dumped" into the economy, it's money that people want to hold for reasons of prudence and safety. Nobody holds onto currency they don't want, and nobody is being forced or encouraged to hold bank savings deposits, since they yield almost nothing.

For the past 5 ½ years, the public has had a very strong demand for cash, cash equivalents, and short-term securities, even though they "cost" over $1 trillion to hold. The public has been willing to pay this inflation tax because the public has been very risk averse. However, as I've noted before, risk aversion is on the decline. As time passes, the public will be less and less likely to want to hold safe assets that carry with them a significant inflation tax. Banks too will be less willing to hold the current $2.6 trillion of excess reserves that currently pay only 0.25%; they will be more likely to use them to increase lending, which could potentially yield a lot more. All of this will make more urgent the need for the Fed to reverse its QE efforts by draining reserves and increasing the interest it pays on reserves, lest a surfeit of bank reserves lead to an excess of money supply vis a vis money demand—the classic prescription for rising inflation.

As money demand declines, the public will want to reduce its holdings of money and safe assets in favor of assets with a positive real yield. A reduction in money demand will thus put inexorable pressure on short-term yields to rise and riskier asset prices to rise. Some might call this a "melt-up," and it wouldn't be far-fetched.

Buffet's "Bubble Red" Indicator

You may have noticed a recent post on Zero Hedge ("Forget Shiller's CAPE, Warren Buffet's 'Best Indicator' Is Flashing Bubble Red"). It includes a chart that shows the market value of U.S. companies as a % of nominal GDP, and it does look scary: by this measure equity valuation is almost as extreme as it was in early 2000.

I can't vouch for the data behind the ZH graph, but I can vouch for the data used to create the above graph. In my experience, the S&P 500 index has been the best measure of the performance of the U.S. stock market, and it has also been the best proxy for the value of U.S. corporations. What I think this graph shows is that the ratio of company valuations to GDP is not yet extreme, being approximately equal today to what it was in the early 1960s when inflation was low and stable and U.S. interest rates were low and stable, much as they are today.

If I had to guess, I would say that over the next several years nominal GDP growth will pick up (it was a meager 1% or so in the first half of this year), while the growth of equity prices will slow down. Both of those developments would be consistent with higher bond yields and a leveling off of the equity/nominal GDP ratio. In other words, we're not necessarily in an equity bubble, and an equity bubble is not necessarily inevitable.

Job security doesn't get much better than it is today

First-time claims for unemployment last week came in much lower than expected. This is more good news for the jobs market and the economy, since it means that businesses are facing very low levels of stress.

Relative to total jobs, the current level of claims is now about as low as it has ever been. The average worker has never had such a high level of job security—think of the above graph as a measure of the probability that a worker is laid off in any given week.

Recovery rests on solid, not liquid ground

It's not hard to find analysts who argue that this recovery owes everything to the Fed's massive injections of liquidity. By pumping money and keeping short-term interest rates near zero, the Fed has forced liquidity into risky assets, thus propping up equity prices excessively and artificially.

As long-time readers of this blog know, I think that argument is weak at best. The Fed has not been printing money with its Quantitative Easing programs. The Fed has simply been swapping bank reserves (which are functionally equivalent to T-bills) for notes and bonds, and they have been doing this in size in order to accommodate the world's demand for safe assets. The Fed hasn't been dumping tons of new money into the system, the Fed has been supplying liquidity that the market demanded. We haven't seen any unusual increase in inflation because the Fed's supply of money has been equal to the demand for money.

But even if the Fed were "pumping" money into the economy, it's a stretch to think that extra money can translate into real growth. If printing money could make an economy grow, Zimbabwe and Argentina would be economic powerhouses—but they aren't. Printing money that no one wants is the basic recipe for inflation, and that's not been the story of the current business expansion in the U.S. economy.

Here are some charts that focus on the physical growth of the U.S. economy. This is real growth, not make-believe, liquidity-driven growth.

Manufacturing production (the volume output of industrial establishments in mining, quarrying, manufacturing, and public utilities) has increased by 25% in the past five years. It's almost at a new all-time high. The manufacturing side of the economy survived, and has largely recovered from, its steepest plunge in history.

Actual shipments by truck, rail, waterways, pipelines and aircraft, as measured in ton-miles by the Dept. of Transportation, has increased over 25% in the past five years, and is now at a new all-time high.

Truck tonnage, as measured by the American Trucking Association, has increased by almost 30% in the past five years and is now very close to its all-time high. As the above chart shows, there is a decent correlation between the level of truck tonnage and the real value of the equity market. When the physical size of the economy increases, so do equity prices in real terms. Furthermore, equity prices do not appear excessive when compared to the increase in the physical size of the economy. (They did look excessive in 2000, however, and they looked extremely depressed in 2009.)

The nation's architectural firms report an increasing number of billings, a good sign that the commercial real estate market is expanding.

New housing starts are up about 80% in the past five years, and builders appear reasonably confident that construction activity will continue to increase.

U.S. exports of goods have increased 65% in the past five years and are at a new all-time high.

World trade volume has increased almost 35% in the past five years, and is now at an all-time high.

U.S. crude oil production has surged over 70% in the past five years, with the result that the U.S. has surpassed Saudi Arabia as the world's largest oil producer. Back in 2008 this would have been unthinkable, and it's all due to the ingenuity of oil producers (i.e., fracking technology).

A composite index of chemical industry activity has increased 27% in the past five years, and has grown by 4.3% in the year ending June 2014—a good indicator that the U.S. economy continues to grow.

The private sector has created almost 10 million jobs in the past four years, and private sector jobs are now at a new all-time high. 

The jobs market is stronger and unemployment is lower primarily because fixed investment (e.g., investment in new things—new buildings, new homes, new plant and equipment) has increased faster than the overall economy.

There's still a lot of room for all of these indicators to improve. It's still the case that this has been the weakest recovery in history. But it is nevertheless a recovery, and the economy has without question been growing in a real, physical sense. This is a genuine economic expansion, and the rise in equity prices is a reflection of that growth. It's not a liquidity-driven mirage, it's real.

Commercial real estate enjoys double-digit growth

Commercial real estate prices have yet to exceed their pre-recession highs, but they are getting close, according to the repeat-sales indices of the Co-Star Group. As the chart above shows, Co-Star's value-weighted index of commercial property prices has been rising at about a 10% annualized rate for the past four years. That's a pretty impressive recovery in my book, even though prices in inflation-adjusted terms are still 12% lower than their 2007 highs. (The Value-Weighted Index is a more liquid, and thus more reliable and more responsive index, than the Equal-Weighted Index.)

The first thing I think about when looking at a chart like this is that it flies in the face of the Fed's ongoing concern about the health of the U.S. economy. Short-term interest rates shouldn't be at zero in an environment of double-digit price gains for the commercial real estate sector, since it invites excessive speculation.

For the time being, however, it looks like commercial real estate will continue to boom. As Calculated Risk notes, distress sales have been steadily declining for the past 3 years. As Co-Star notes, "in the early-recovery, coastal markets of Los Angeles, San Francisco and San Jose, distress levels are nearly non-existent."