Tuesday, March 18, 2014

The end of deleveraging

In my post of yesterday, I noted the importance of the decline in the private sector's demand for safe, short-term assets (e.g., bank savings deposits). I think this is a sign that the risk pendulum has stopped swinging in the direction of risk-aversion and is beginning to reverse; it's a sign that the public will begin to embrace risk rather than shun it. This has very important implications for monetary policy, since the whole point of the Fed's QE efforts has been to satisfy the private sector's seemingly insatiable demand for safe assets. As I explained before

With its QE bond purchases, the Fed has simply "transmogrified" notes and bonds into T-bill equivalents in order to satisfy the world's risk aversion and the very strong demand for cash and cash equivalents. Weak confidence has created strong demand for money, and that has kept the Fed's "stimulus" from turning into inflation.

If the world's demand for safe assets has been sated; if the private sector's desire to de-risk and deleverage is at an end; then the world's demand for "money," cash, and cash equivalents is going to decline. I mentioned yesterday that bank savings deposits have not increased at all since early January. Today we have more evidence that points in the same direction: household's financial burdens have stopped declining.

The chart above contains data released today by the Fed through the end of 2013. Households' financial obligations (e.g., debt payments as a % of disposable income) reached a high in 2008, but have since declined significantly. Importantly, the decline appears to have ended last year. This means households have rebuilt their balance sheets and restructured their finances to the point where they no longer need to tighten their financial belts. Financial burdens today are as low as they have been at any time in the past three decades.

As the chart above shows, households' leverage—liabilities as a % of total assets—has declined significantly since hitting an all-time high in early 2009. Leverage is now back to levels not seen since 2000. In a sense, all of the excessive speculation that helped fuel the housing boom in the early- to mid-2000s has been reversed.

This same de-risking and de-leveraging shows up in credit card and consumer loan delinquency rates. As the chart above shows, delinquency rates for consumer loans are now at an all-time low. Households have bolstered their finances and tightened their financial belts in an impressive fashion, with some help, of course, from tighter bank lending standards. Banks are now sitting pretty, with the lowest consumer loan delinquency and chargeoff rates in decades. Lending standards are very likely to be relaxed going forward, and this will facilitate the expansion of credit and the decline in the demand for money.

If it isn't already, the financial pendulum could soon be swinging back toward re-risking and re-leveraging.

This is extremely important, since it means the public's appetite for debt is likely to increase, PE multiples are likely to rise, the demand for money is likely to decline, and nominal GDP growth is likely to increase. 

If the Fed doesn't take steps to tighten monetary policy in response to this important shift in the demand for money, there could be inflationary consequences.

We see a hint of this in the price of gold (see chart above), which has risen from $1200/oz. to almost $1400/oz. in the past several months. The rise in gold coincides with the surge in bank lending which I noted yesterday, and with the lack of growth of bank savings deposits, and with the dollar's 2% decline since mid-January. All are consistent with a decline in money demand which has not been offset by a tightening in the supply of money by the Fed. These are early warning signs of higher inflation in the months and years to come.

We've seen a version of this movie before, only in reverse, in the wake of the S.E. Asian currency crisis of 1997-98. As one currency after another collapsed vis a vis the dollar, this created intense demand for dollars. Yet the Fed at the time was busy tightening monetary policy, pushing real yields up to 4-5% in an effort to "cool" a supposedly "overheated" U.S. economy. Strong demand for dollars combined with the Fed's efforts to restrain the supply of dollars pushed the dollar up by almost 50% from 1995 to 2002, and that in turn pushed inflation to the lowest levels we had seen in decades and crushed the prices of commodities and gold. Deflation was a genuine risk in the late 1990s, as Alan Greenspan himself noted in 1998. Yet markets weren't worried about deflation back then. The predominant concern was that the economy was so strong (real growth was running 4-5% in the late 1990s) that it would push inflation higher.

Today it's pretty much the same, only opposite. Markets are worried that the persistently weak growth of the economy and the low rate of resource utilization (e.g., high unemployment) will lead to falling prices, even though monetary conditions are now conducive to rising prices. The confusion arises from the persistence of flawed Keynesian-Phillips-Curve thinking—the belief that inflation is caused by too much demand and deflation is caused by too little demand. Janet Yellen has been enamored of this way of thinking for years, so there's a real risk that she may make the same mistake that Greenspan made in the late 1990s, only in the opposite direction, with the result that inflation rises in the years to come. It wouldn't be the first time that markets have been blindsided by monetary policy.

Measured inflation is still quite low, as the chart above shows. Both core and headline inflation are running at a rate of about 1.5%, which is appreciably lower than the 2.3% annualized pace of the past 10 years. The lags between monetary policy shifts and their impact on prices and the economy can be long and variable, as Milton Friedman taught us. Today's low inflation is likely a lagged response to the Fed's slow response to the intense increase in the demand for money and safe assets that occurred in the wake of the financial crisis of 2008. If the Fed has erred by moving too slowly to taper in recent months that doesn't mean inflation is necessarily going to jump tomorrow or even in the next few months. There is still time to bring policy back into line with the changing demand for money, but the spotlight on the Fed is going to be intense as the year unfolds.

Stay tuned.


Benjamin Cole said...

Terrific post...still, the global experience seems to be a secular trend towards ZLB...Japan there, Europe close, and we will see about USA...given that the supply side has become global, I see no chance for serious inflation in the USA...the Fed target is 2 percent on the PCE deflator and we are at half of that...

PD Dennison said...


The US 10 Treasury is at 2.7%, while the Spain and Italy 10 YR is at 3.3% and dropping fast.

Can the US and Spain have an equal 10 YR rate? Can the US inflation risk match the default/currency risk of Spain?

It seems to me that the weak Europe, Japan, EM with a slowing China all point to continue weakness as the US heads to a Europe/Japan stagnant economy. (Though some real change in Washington might change this).


Scott Grannis said...

The relevant benchmark for Spain is Germany, since they both share the same currency and Germany's credit is virtually bullet-proof. German 10-yr yields are 1.6%, so Spain and Italy are double that. A spread of 170 bps makes Spanish debt roughly equivalent to a low quality (BBB-) corporate bond. Not exactly outrageous, but certainly it reflects tremendous improvement in Spain's prospects.

Much of the world seems afflicted with sluggish growth. It's hard to get excited about a big growth pickup in the absence of improvements in fiscal and monetary policy. Nevertheless, it appears that the private sector in the U.S. is becoming more comfortable with taking on risk. Whether additional risk-taking is enough to overcome the drag of our fiscal policy (high tax rates and huge regulatory burdens) and give us stronger growth is the question of the day. For now, the path of least resistance seems to be higher prices for risk assets and higher PE multiples.

Hans said...

Credit is not money? Someone please help with that one or is this econotalk?

Scott Grannis said...

Demand for credit is the opposite of the demand for money. Borrowing is equivalent to being short money.

Credit can grow without there necessarily being any growth in the amount of money.

Anonymous said...

If I understand correctly, I think what Scott is saying is that "demand for money" is basically hoarding cash. When you are hoarding cash you don't need a lot of loans (credit) because you already have lots of your own cash. When you stop hoarding cash - that is, your demand for money goes down - that means you need more cash than you have, and thus, need loans (credit).

Benjamin Cole said...

Remember...globalized economy...Fed prints money (int'l reserve currency), more demand and more supply created...the USA is only a player on the world stage, so inflation is very limited...copper weak btw, although the link between commodities and inflation dead...
Some moderate sustained inflation would be a good thing...help deleverage, boost real estate...but likely we will see inflatoon in one percent range...the Fed is fighting the last war...

Hans said...

Thank you, Mr Grannis and Unknown.

invest2bfree said...


I really appreciate everything you do.

If not for Brian Wesbury I would have not found you and you are responsible for retail investors like me to see clearly what the institutions are seeing.

Thanks agsin

Scott Grannis said...

invest: Thank you for your kind words!

Lucas said...

I believe the drop in household leverage is due to the increasing value assets, not the decrease in household debt. Look at your chart from March 6th... Debt is flat, financial assets are up, therefore leverage is down.

What happens if the stock market collapses again?