Households have finished deleveraging

I've been following this issue for more than two years because I think it has very important implications for the future of Fed policy. One of the defining characteristics of the current recovery has been a widespread risk aversion, which in turn has led to a significant amount of deleveraging and a simultaneous increase in money demand on the part of U.S. households. The Federal Reserve's Quantitative Easing operations were essentially designed to accommodate this, since the net result of QE was to transmogrify notes and bonds into risk-free, short-term assets which, in turn, satisfied the risk-averse public's increased demand for money and money-like balances.

One important consequence of risk aversion is the desire/need to deleverage and otherwise reduce debt burdens. (Jargon note: reducing debt and debt burdens is equivalent to an increasing demand for money; having debt is like being short money—reducing debt is equivalent to going long money.) There are many ways to do this: paying down debts, canceling debts, refinancing debts at a lower interest rate, saving more money, and accumulating more assets. The massive increase in risk aversion in the wake of the financial crisis of 2008 manifested itself in an equally massive increase in the demand for money, money equivalents (e.g., bank savings deposits), and safe assets (e.g., short-term TIPS, gold). The Fed accommodated that risk aversion by buying notes and bonds and creating bank reserves. Banks have invested essentially all of their $3.5 trillion increase in bank savings deposit inflows since late 2008 in excess bank reserves which they still, apparently, are content to hold.

As the chart above shows, as of June 2014, households' financial burdens (debt and related payments relative to disposable income) had fallen significantly from their pre-recession high, but they have been unchanged for more than a year. Households responded to too much indebtedness by going bankrupt, writing down debt, paying down debt, getting new jobs, earning more income, refinancing debt at lower interest rates, and by saving more. But it is becoming increasingly apparent that households'  desire to delever has all but evaporated. That implies that the next chapter in this story, whenever it begins, will involve increasing indebtedness and a decline in the demand for money and safe assets. There are already signs that this is happening, most notably the increased growth rate of C&I Loans that we have seen year to date, the weakness in gold prices, and the decline in the real yield on 5-yr TIPS.

The chart above shows that, as of June 2014, households' leverage (total debt as a % of total assets) had declined by more than 25% from its recession-era high. As with debt burdens, leverage has declined thanks to a variety of factors: less debt, lower interest rates, more savings, and rising equity and housing prices. Household leverage is now back to the levels of the mid- to late-1990s, a period that saw low inflation and strong economic growth. The "bubble" that was created in the runup to the 2008 financial crisis has completely popped. Households have adjusted to new realities, so perhaps we'll see more normal, less risk-averse behavior going forward.

Even the federal government's borrowing binge has faded. The FY 2014 federal budget deficit was a mere 2.8% of GDP, down from a high of over 10% in late 2009. In dollar terms, the federal deficit declined by an impressive two thirds in just over the past four years. The federal government hasn't yet actually deleveraged (federal debt outstanding is now at a post-war high of about 72% of GDP, as shown in the chart above), but it is no longer leveraging up by leaps and bounds.

An important part of the big decline in debt burdens and the big deleveraging of household's balance sheets has been an increase in holdings of "money" and money equivalents. The M2 measure of the money supply is arguably one of the best measures of money, and the chart above shows the current composition of M2. Savings deposits are by far the largest component, and they have grown by $3.5 trillion since the onset of the 2008 financial crisis. But the growth rate of savings deposits has been declining in the past year or so, from a high of 18% in 2010 to just 5% in the past 6 months. This is consistent with a decline in risk aversion and a decline in the demand for money on the margin.

The big increase in money demand shows up clearly in the chart above. It plots the ratio of M2 to nominal GDP. Since the onset of the 2008 financial crisis, the public has increased its holdings of "money" relative to nominal income by more than 20%. That's equivalent to the typical household deciding that they need to increase their holdings of cash by an amount equal to one-fourth of a year's income. That's a lot of money that has been "stockpiled" on the sidelines—upwards of $2.2 trillion. If the demand for that money should ever decline—because, say, risk-taking becomes the vogue—it would be like opening the floodgates: a wave of extra liquidity would wash through the economy, boosting nominal GDP and likely raising prices. Unless, of course, the Fed tightens monetary policy by enough to offset the decline in money demand. It would probably take much higher interest rates to convince households to continue to hold their sizable savings deposits in a world with much less risk aversion.

So this is where we stand today. The great era of risk aversion and deleveraging is fading into the past. It is gradually being replaced by a new era of more confidence and a desire to embrace risk and shun safe assets that yield almost nothing. This bodes well for equities and the economy, but it also creates a serious risk of inflation, should the Fed fail to accommodate the declining demand for money in a timely fashion.