More thoughts on the banking crisis

By calling into question the value of a significant portion of the country's bank deposits, the recent failure of one or more regional banks is equivalent to a sudden tightening of monetary policy, in which the supply of money is perceived to have contracted while the demand for the remaining portion has increased.

Background: The "ideal" money can be defined as a highly liquid, universally-accepted medium of exchange that holds its value over time and can—but not necessarily—also pay a floating rate of interest, e.g., currency, checking and demand deposits, and retail money market funds. M2 incorporates all of these and is thus an excellent way to track the supply of money.

Therefore, we might say that the current banking crisis is being caused by the perception that some portion of M2 (e.g., bank deposits in regional banks) may lose—or may have already lost—value in the event of a bank failure or expected bank failures. That perception automatically triggers an increased demand for the rest of M2. Together, this has the same effect as a sudden tightening of monetary policy; the supply of money has decreased at the same time the demand for money has increased.

If the Fed does not offset this effective tightening by reducing interest rates, things could get ugly. Reducing interest rates does two things: 1) it makes holding money less attractive on the margin, and 2) it makes borrowing money more attractive on the margin. This serves to reduce the demand for money while at the same time increasing the supply of money (because an increase in loans expands the supply of money). Together they amount to a relaxing of monetary policy, and that is the appropriate response to a sudden and unexpected tightening of monetary policy.

The Federal Open Market Committee (FOMC) meets on Wednesday, March 22, at which time they are expected to make what is now an extremely important decision: will they raise rates, hold rates steady, or cut rates? The market seems to expect they will most likely hold rates steady. I would argue they should cut rates, as my argument above suggests, and I hope they do.

Some helpful charts for background follow:

Chart #1

Chart #1 shows the inflation-adjusted value of the dollar relative to a trade-weighted measure of other currencies. By any measure the dollar is strong, and significantly stronger than it has been for most of the past half-century. Judging by this evidence, the dollar is still the world's premier currency. We could also infer that there is no excess supply of dollars relative to the world's demand for dollars. This further suggests that a sudden tightening of US monetary policy (as described above) could boost the dollar's value further, thus negatively impacting nearly every other currency on the planet. A strong currency is very important, as is a stable currency. A strong and appreciating currency is not necessarily a good thing.

Chart #2

Chart #2 compares the value of the dollar (using a popular but less robust measure of the dollar's value than that used in Chart #2) to the inflation-adjusted price of gold. (Note: I have inverted the dollar, so a falling blue line represents a stronger dollar.) If the dollar and gold were competing "safe ports in a monetary storm" then a stronger dollar might coincide with a lower gold price, and vice versa. That has been the case of many years, as the chart suggests. In recent years, however, the dollar has appreciated alongside a rising gold price. Is the dollar "too strong," or is gold "too strong?" I don't have a good answer to that, unfortunately.

Chart #3

Chart #3 shows the level of the Fed's balance sheet. Last week, the Fed's balance sheet jumped by about $300 billion, the result of the Fed extending credit to troubled banks in exchange for those banks posting notes and bonds as collateral for an emergency loan. Did the supply of money also increase? We won't know the answer to that question until the release of March M2 statistics on April 25th. I would also note that there has been no appreciable shrinkage in the Fed's balance sheet despite their professed intention to do so.

Chart #4

Chart #4 shows the level of bank reserves held on deposit with the Fed by the nation's banks. For decades prior to 2008, bank reserves were only a tiny fraction of what they are today. That's because bank reserves paid no interest prior to 2008, and banks were required to hold reserves in order to collateralize their deposits. Thus, banks held only the absolute minimum amount of reserves they were required to hold. After 2008, the Fed began paying interest on reserves, and so banks came to view reserves as a valuable asset: highest quality, risk-free, default-free, and paying a floating rate of interest. In short, reserves came to be viewed as functionally equivalent to T-bills, and banks were happy to load up on their holdings of reserves. 

By any measure, and from an historical perspective, there is an abundance of bank reserves today. The Fed is not significantly restricting the supply of this very important asset like they did prior to 2008, when the Fed intentionally restricted the supply of reserves in order to boost market interest rates (banks that wanted to expand their lending were forced to borrow reserves from other banks, and that boosted short-term interest rates). That is one good reason to think that the banking system and financial markets today are more resilient than in prior Fed tightenings.

Chart #5

Chart #5 shows the level of 2-yr swap spreads. (See my swap spread primer here.) This is an all-important measure of liquidity in the banking system (the lower the spread the greater the liquidity) as well as the financial health of the economy (the lower the better). Note that in the wake of the SVB crisis, swap spreads have fallen. This dovetails with Chart #5 in the sense that both suggest that there is abundant liquidity in the banking system, and that's a very good thing.

Chart #6

Chart #6 shows the level of Credit Default Swap spreads, which is a very liquid and generic indicator of the market's perception of the health of corporate profits, and by inference the health of the economy. These spreads have risen somewhat in the wake of the SVB crisis, but not significantly, and that's a good thing, since it means the economy is not likely on the cusp of recession.

Chart #7

Chart #7 shows the level of nominal and real 5-yr Treasury yields and the difference between the two, which is the market's expectation for what CPI inflation will average over the next 5 years. By this measure, the market is saying there is almost no problem with the outlook for inflation. Whatever the Fed has done to date has been sufficient to tame the inflation beast that awakened (unexpectedly, for those who have not followed this blog) over a year ago. 

Chart #8

Chart #8 shows the year over year and 6-mo. annualized rate of change in the Producer Price Final Demand index (i.e., inflation at the wholesale level). Both measures have dropped significantly from their peaks of last year. This is a good approximation of what we likely will see happening with the CPI over the course of this year. 

Swap and credit spreads say no recession

Today the market was rattled by news that Silicon Valley Bank (SIVB) was forced to sell most of its bond portfolio at a nearly $2 billion loss and will now have to raise additional capital to remain solvent. The question on everyone's mind: is this the first inning in a replay of 2008's financial crisis? Aggressive Fed tightening over the past year or so has devastated the value of bond portfolios because interest rates have risen by more and faster than during any prior bond bear market. To make matters worse, Chairman Powell two days ago declared that the Fed may well have to raise rates by even more than they expected, in large part because the economy is proving stronger than expected.

So what is it? Will the SIVB collapse mark the beginning of another financial crisis which in turn triggers the long-awaited recession? Or is the economy so healthy that the Fed will need to raise rates even more? Inquiring minds would like to know how these two fears can coexist.

I don't pretend to know the answer, but I do know that—outside of the now-famous inverted yield curve—it's difficult to find any signs that a recession is around the corner. A big disappointment in tomorrow's jobs number might persuade me to become less complacent, however.

I also know that, thanks to the decline in M2 and today's much higher interest rates, inflation pressures peaked some months ago and inflation is quite likely to decline over the course of this year as it returns to the Fed's 2% target. Following are some charts that round out the story:

Chart #1

Chart #1 shows the level of 2-yr swap spreads in the U.S. and Europe. These spreads have an uncanny ability to predict the onset and end of recessions (higher spreads predict bad news for the economy, and lower spreads predict better news). Eurozone swap spreads are still elevated, but they have come down significantly in recent months—thank goodness. U.S. swap spreads are only modestly elevated (a "normal" range would be roughly 15 to 35 bps) and they too have been declining of late. No signs of a recession here.

Chart #2

Chart #2 shows the level of corporate credit spreads. Like swap spreads, these too tend to predict the beginning and end of recessions. Current levels reflect substantially "normal" conditions. The bond market is signaling that the outlook for the economy is generally healthy, and liquidity conditions are good. No signs of a recession here.

Chart #3

Chart #3 is another way of looking at the spreads in Chart #2: the line represents the difference between high-yield and investment-grade spreads, otherwise known as the "junk spread." Here it becomes perhaps clearer that conditions today are pretty normal.

Chart #4

Chart #5

Charts #4 and #5 focus on Credit Default Swap Spreads, which are highly liquid and quite representative of generic credit risk. Here too its difficult to see signs of distress. 

Chart #6

Chart #6 shows the level of 30-yr fixed mortgage rates. Never before have they risen so much in so short a time. This has caused profound distress in the nation's real estate market. Real estate is the one area of the economy that is really suffering, but as the previous charts suggest, this suffering has not been contagious to the broader economy. One positive thing to note is that there is not a large overhang of new construction or a significant inventory of homes for sale (like we had in 2005-2006). The solution to the current real estate problem is not a collapse but a repricing: housing prices went up too far given the simultaneous surge in financing costs. The solution is simple, but it may take awhile to play out: prices need to fall and interest rates need to decline.

There is one good thing to note here: higher interest rates are having a big impact on asset markets, which in turn implies that Fed tightening is working. The Fed doesn't need to do much more, if anything.

Chart #7

Changing the subject, Chart #7 shows a very important macro statistic that is generally ignored by the financial press. Households' real net worth fell by about 9% last year, but it is not out of line with historical experience. As the green line suggests, this measure of our nation's well being has improved by about 3.6% per year for many decades, and the current level of real net worth is right in line with the long-term trend: $148 trillion.

Chart #8

Chart #8 is remarkable in that the jobs market is apparently more healthy today than it has been in a long time. Job openings are near record highs, and they exceed the number of people looking for work by a record margin. Some employers are shedding workers (e.g., the tech sector), but most others are having difficulty finding people willing and able to work. This is not the sort of situation that precedes recessions.

M2: the smoking gun of inflation

Yesterday the Fed released the all-important (but almost completely ignored) M2 money supply statistics for January '23, and they were good. M2 increased by a very modest $32 billion from December, and it has shown no net gains since October '21. Year over year M2 growth is -1.7%, and 6-mo annualized growth is -3.4%.

M2's huge growth from 2020 through 2021 provided the fuel for the inflation that has rocked the economy for the past year, and it's great news that it's fading away. The growth of M2, by over $6 trillion in two years, was the result of the monetization of roughly $6 trillion of Treasury debt issued to fund a tsunami of federal transfer payments in that same period. Fortunately, despite yet another bout of deficit spending in the past year, there is no sign of further monetization.

It is still mind-boggling to me that the unprecedented growth of M2 has almost completely escaped the public's notice. Most surprising of all: how in the world could the Fed not see it? Why was there only a handful of economists who commented on it, as I noted a year ago? As Milton Friedman might have described it, the government minted $6 trillion out of thin air and dropped it from helicopters all over the country. How could that not have resulted in higher prices? 

In any event, here we are; the flood of funny money is receding. That's why there is now plenty of light at the end of the inflation tunnel.

Chart #1

Chart #1 is the main attraction. The M2 money supply exploded from $15.5 trillion in February '20 to $21.5 trillion in January '22. Since then, M2 growth has turned negative, and today M2 is only $3.4 trillion above where it might have been in the absence of the Fed's "helicopter drop." The gap is closing, and the money printing presses have been shut down. Inflation pressures peaked almost a year ago, and headline inflation will almost certainly continue to subside. 

Chart #2

Chart #2 shows the 6-mo. annualized growth rate of M2, which is now -3.4%, down sharply from a high of over 40% in August of 2020. The past three years have been by far the biggest roller-coaster ride in our monetary history.

Chart #3

Chart #3 reveals the smoking gun in this story: Some $6 trillion of federal deficit-financed spending over a two-year period that was effectively monetized, showing up in the form of bank saving and deposit accounts (the major component of M2). At first this was fine, because the public was not willing or able to spend it—the demand for money was intense. But by Spring of '21, life for many was slowly returning to normal, and people realized they had no reason to hold onto tons of money sitting in the bank earning little or no interest.  Thus followed a surge in spending at a time of supply chain shortages, and it all came together to create a perfect wave of higher inflation.

Chart #4

Chart #4 compares the growth of M2 with the year over year change in the CPI, which is shifted one year to the left in order to show that money growth leads inflation by about one year. This chart further suggests that the year over year change in the CPI will gradually fall to the Fed's 2% target over the course of this year, thanks to the huge deceleration in M2 growth over the past year.

Chart #5

Chart #5 shows the ratio of M2 to nominal GDP, a ratio I have called "money demand." Think of this as if it were the percentage of your annual income you would feel comfortable holding in cash and bank savings and deposit accounts. Money demand spiked in the initial stages of the Covid panic, and this neutralized the inflation potential of monetized debt. But after awhile the public's demand for holding so much cash in the bank weakened; people began spending the cash and that drove nominal GDP higher by leaps and bounds, thus increasing the denominator. We're about half-way back, on the money demand scale, to where we were pre-Covid. Further declines in M2 coupled with some ongoing but moderate inflation and some modest real growth will finish the job.

Chart #6

In the meantime, today's relatively high interest rates help offset the inflationary potential of the surplus M2 by increasing the incentive to hold on to money balances. Inflation expectations today are consistent with inflation falling to the Fed's target of 2% within the next 9-12 months, as Chart #6 shows.

The Fed doesn't need to do more than they already have. The lower-inflation wheels have been set in motion.