In the Old Days (pre-2009), when bank reserves paid no interest—they were considered a "dead" asset—banks held the minimum amount of reserves necessary to collateralize their deposits. When the Fed needed to bring inflation down (usually as the result of a prior mistake that allowed inflation to rise), the Fed restricted the supply of reserves in order to force their price (the cost of borrowing reserves) higher, and to slow the growth of the money supply and bank lending. Higher interest rates and a scarcity of money eventually did the job, but unfortunately, a recession typically followed, heralded by sharply rising credit spreads.
Around the end of 2008, the height of the financial panic at the time, the Fed made a momentous decision: reserves would become an interest-bearing and default-free asset, and there would be plenty of them. The Fed would control short-term interest rates directly, without having to restrict the supply of reserves. The Fed would pay interest on reserves using funds it received on its holdings of Treasury and mortgage-backed securities, which in turn were purchased by issuing reserves. Reserves effectively became T-bill substitutes, and as such, an ideal asset for the banking system.
At first, most analysts, myself included, feared that an abundance of reserves would result in a surge of lending and higher inflation. Fortunately, that didn't happen. In fact, for the next 11 years, inflation and interest rates would be low and relatively stable. In the first half of 2009 I stopped worrying about abundant reserves becoming inflationary, because I realized that banks had an almost insatiable appetite for holding reserves. The supply of reserves had exploded, but so had the demand to hold them. Thus, abundant reserves were not inflationary.
Then came Covid-19, and panicked politicians shut down the economy. To compensate for the loss of income which followed, Treasury sent roughly $6 trillion in checks to individuals and companies over the course of the next 18-20 months. Initially, most of the extra money sat idle in bank savings and deposit accounts. Then, in early 2021, as the economy began to get back on its feet, people began to spend the money, only to find that supply chains had been disrupted. Demand for goods and services soon outstripped supply, and inflation took off. If Milton Friedman had been alive at the time, he would have realized that his helicopter-drop-of-money analogy had become real: dumping trillions of extra dollars on the economy had ballooned the price level by 20-25%. In early 2021 I began forecasting a serious increase in inflation because I realized that the demand for all the extra money that had been created was beginning to decline.
To its everlasting regret, it took the Fed a year or so to figure out that rising prices were not in fact "transitory," but the real thing. So in March '22 they began the process of tightening by raising short-term interest rates. It wasn't easy to break the back of inflation, because the supply of money (M2) had surged by $6 trillion; they not only needed to reduce the money supply but to persuade (via higher interest rates) people to not spend the money so fast. Meanwhile, pundits and economists of every stripe predicted that, as it always had over the previous 50 years, a recession would inevitably follow the Fed's energetic monetary tightening. Very few, myself included, thought that a monetary tightening that occurred during a period of abundant reserves and ample liquidity would not result in a "hard landing."
To the great surprise of nearly everyone, we have experienced a "soft landing." The Fed has regained control of monetary conditions, inflation has come down to its target, and the economy has managed to grow at a decent rate throughout the tightening process. Abundant reserves arguably were the key. Thanks to abundant reserves, liquidity has been abundant in the financial markets as evidenced by low and relatively stable credit spreads. Financial markets were thus able to act as a shock absorber for the disruption to the economy caused by higher prices and higher interest rates.
Unfortunately, as Milton Friedman famously said, there is no free lunch.
Supercharged federal spending has distorted the economy by not only causing inflation, but also by transferring trillions of dollars from the productive sector of the economy to consumers and enlarging the size of the government in the process. Pre-Covid, the federal deficit was almost $1 trillion per year. Currently, the deficit is running at almost a $2 trillion annual rate. Government payrolls have surged at a more than 2% annual rate since early 2023, even as private payroll growth has slowed from 4% in late 2022 to now only slightly more than 1%. Government spending has been the main source of economic growth in recent years, while business investment and manufacturing have been weak. This is not a prescription for solid growth in the years to come. Although real GDP growth in recent years has been about 2.2-2.4% annually, it is likely to slow down in the years to come unless policy shifts in favor of investment rather than transfer payments.
Chart #1
Chart #1 illustrates the gigantic increase in bank reserves that began in late 2008 when the Fed decided to make reserves abundant while also paying interest on reserves. Prior to that, reserves were a direct constraint on bank lending, since banks needed to hold reserves to collateralize their deposits, and reserves paid no interest. QE4 (aka massive Covid-related "stimulus") was the proximate cause of our destructive bout of inflation in recent years. Prior episodes of Quantitative Easing were not inflationary because they were neutralized by strong demand for cash and cash equivalents.
Chart #2
Chart #2 shows the difference between credit spreads on investment grade and high-yield corporate debt. This is an excellent measure of future economic health and financial market liquidity (higher spreads reflect concern about corporate profits and a general shortage of liquidity, while lower spreads reflect optimism about future economic growth and liquidity). Big spikes in credit spreads have reliably predicted recessions. Today, credit spreads are very low, and recession risk is also low—but that doesn't rule out sluggish growth.
Chart #3
Chart #3 shows the level of real economic growth (blue line) and different trend growth rates. The 3.1% annual trend line was in place from the mid-1950s through late 2007, while the 2.3% trend line began in mid-2009. If the economy had followed that 3.1% growth rate following the 2008-9 recession, it would be about 20% larger today.
Chart #4
Chart #4 shows the year over year change in the GDP deflator, the broadest measure of inflation. From a peak of almost 8% it is now only slightly above 2%. This confirms that the Fed has succeeded in controlling inflation. Unfortunately, the price level today is still almost 20% higher than it would have been if inflation had been instead averaged less than 2% per year, as it did in the decade leading up to Covid.
Chart #5
Chart #5 shows the 6-mo. annualized change in the Personal Consumption deflator and its core (ex-food and energy) version. By these measures inflation is also once again under control.
Chart #6
Chart #6 shows the three components of the Personal Consumption deflator. Service prices, dominated by shelter costs, are the only ones rising. Non durable goods prices are almost unchanged for the past two years, while durable goods prices have been declining for two years. Deflation in the durable goods sector has returned.
Chart #7
Chart #7 is a reminder that every recession prior to the Covid recession was the result of tight monetary policy. Monetary policy was tight because real interest rates were very high and the Treasury yield curve was inverted. Those two conditions have returned of late, but there is no recession in sight. What's different this time? Abundant reserves.
Chart #8
Chart #8 shows the ISM purchasing managers survey of the manufacturing sector. This has been notably weak since late 2022. That the economy has grown by almost 3% in the past year is due almost entirely to government spending and transfer payments.
Chart #9
Chart #9 shows the monthly change in private sector payrolls over the past 3 years, as well as the rolling 6-mo average of same. In early 2022, payrolls were growing by about 600,000 per month; now they are growing by only 100,000 per month. (I assume the very low number for October to be the result of hurricanes, strikes, and random variations which can and do happen quite often.) While this is not necessarily a precursor of recession, slow jobs growth does point to a loss of vitality in the economy which could persist and/or worsen. We are not likely to see 3% GDP quarters on a sustained basis; be prepared for 2% or less. At least that will make it easier for the Fed to continue to cut interest rates.
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