Tuesday, August 4, 2015

Why the Fed should raise rates

I've discussed this subject in many posts over the past several months, most recently in "The Fed's game plan: it's all about the demand for money." My point has been, and continues to be, that although the economy is still trudging along at a miserable 2 - 2 ½% growth rate, there are a number of signs that the world's demand for money and money substitutes is declining—and therefore the Fed would be terribly remiss if it failed to respond with measures designed to bolster the demand for bank reserves (e.g., raising the interest rate it pays on excess reserves and allowing reserves to slowly decline as its holdings of securities mature).

Monetary policy has little if any ability to boost the economy's productivity or to encourage more labor force participation, which is what it would take for the economy to grow faster. Liquidity is abundant and systemic risk is low (as can be seen in very low swap spreads). Bank lending is growing at a healthy pace. The economy is not suffering from a shortage of money or a shortage of labor or capital; it's suffering from a shortage of confidence and risk-taking. Corporate profits are at all-time highs relative to GDP, yet capex has been weak for years. I believe that the weak investment climate is mostly attributable to the excessive growth of government in the past 10-15 years (e.g., the rise in transfer payments, the increase in regulatory burdens, and higher marginal tax rates). Not to Fed policy.

Here's a quick run-down of the important indicators I'm watching:

As the chart above shows, gold continues to decline, and the price of 5-yr TIPS continues to fall (note that the chart uses the inverse of the real yield as a proxy for price). Both of these assets are unique, and both offer protections and safety that can't be found in other assets. These assets were extremely expensive not too long ago, when the world was afraid of another financial market collapse following in the wake of the PIIGS crisis. Now, despite the problems of Greece and the slowdown of the Chinese economy, demand for the unique "safety" provided by gold and TIPS is declining. Why? Because the future today doesn't look as bad as it did a few years ago. Inflation has remained low; the dollar hasn't collapsed, it's actually strengthened.

As the chart above shows, the dollar's sharp rise over the past year has only managed to return it to what you might call an "average" level against the world's currencies. The dollar was extremely weak a few years ago, as the world worried that the U.S. would rack up trillion-dollar deficits for as far as the eye could see that would in the end result in a serious debasement of the currency. But instead, the federal deficit today is less than 3% of GDP, and the burden of federal debt has stopped rising. The dollar is not up because the Fed is going to tighten, it's up because the U.S. economy is now more attractive compared to other economies, and because the Fed has done a decent job of managing monetary policy.

And besides, as the chart above shows, the Fed is far from being "tight." What counts is not the nominal short-term interest rate but the real, inflation-adjusted rate. Real short-term rates are still negative, as they have been for the past seven years. Monetary policy won't be tight for a long time; what the Fed proposes for the next few years is real interest rates that are less low. If the world were less risk-averse, the demand for credit would be exploding, given that borrowing money is almost free: everyone would be clamoring to borrowing money. But instead we see that consumers and businesses have been deleveraging, and banks have only recently begun to increase their lending. Why are banks content to sit on trillions of excess bank reserves yielding a negative real rate of interest, when they could be making new loans that paid a lot more? Only because they worry that new loans in the current climate could be very risky. Fortunately, that's changing, but we're still only in the early stages of a big increase in bank lending.

Real rates are up, but nominal rates haven't increased very much of late, even though the bond market knows that short-term interest rates are soon going to rise. That's because inflation expectations have fallen significantly, thanks mainly to lower oil prices, as can be seen in the chart above.

The only thing wrong with lower oil prices is that it puts a lot of pressure on oil producers. That can be seen in the sharply rising credit spreads on energy-related corporate bonds in the chart above. The world worries that defaults could become contagious, but so far, swap spreads in general remain very low, and spreads outside of the energy sector are still relatively low. It's tough in the oil patch, but the rest of the world is delighted with cheaper energy.

In the meantime, banks have been gearing up their lending activities, as the chart above shows. Commercial & Industrial loans (which go mainly to small and medium-sized businesses that can't directly access the bond market) have been rising at a very solid 12% clip since the beginning of last year.

The growth of bank credit in aggregate has also picked up in the past 18 months. Currently it's growing at about a 7-8% annualized rate, which is quite a bit faster than the sluggish growth which prevailed for over 5 years following the 2008 financial crisis.

Banks are the direct source of money supply growth, since they can create money if they have the reserves to back increased deposits. So it's not surprising that money growth, seen in the chart above, has been pretty much the same as the growth of bank credit as shown in the previous chart.

It's also not surprising that the growth of money closely tracks the growth of nominal GDP, as the chart above shows. On average, and over many decades, a dollar of new money translates into a $1.75 of new nominal GDP. However, over the past decade we've seen that money growth has far exceeded the growth of nominal GDP.

Money growth that exceeds nominal GDP growth means that the world's demand for money has increased, as the chart above shows. People want to hold a greater portion of their incomes and their wealth in money and savings accounts. Why? Because they worry. But as the first chart in this post shows, the decline in the prices of gold and TIPS is solid evidence that people are worrying less. The demand for money has been extremely strong, but it is becoming less strong. As a result, it's reasonable to think that nominal GDP will, over the next several years, begin "catching up" to the ongoing rise in M2. There's a lot of money that has been socked away that could begin circulating, boosting both prices and the overall level of economic activity. All it takes is more confidence in the future.

In short, the world is flush with money—trillions of the stuff—but the demand for all that money is beginning to weaken. That's why the Fed needs to raise short-term interest rates. The Fed needs to make bank reserves more attractive, on a risk-adjusted basis, relative to lending money to businesses. Otherwise the world might find itself awash in liquidity that no one wants, and that's the fundamental recipe for higher inflation.

Ah, but shouldn't the Fed worry that inflation is too low? No, because it's not.

As the chart above shows, both the core and the headline Personal Consumption Deflators are within the Fed's 1-2% target range over the past six months. And in fact, the CPI is registering a surprising amount of inflation in recent months. Over the three months ending June, the headline CPI is up at an annualized rate of 3.5%, while the core CPI is up at a 2.3% annualized rate. This is not the stuff of deflation, and interest rates that become less low over the next year or so are not something to worry about.


John McCormick said...

Scott, this might be the dumbest question ever, but... I am going to ask it anyway, and would appreciate any input you have.

Instead of raising rates, why doesn't the Fed start by reversing some or all of the QE they did?

Again, I think this must be a real dumb question, but thank you.

Johnny Bee Dawg said...

Im not Scott, but I don't think the Fed is trying to raise overall interest rates quickly. They are trying to make rates less low for now, and they want that to occur in a measured way, commensurate with the world's lessening demand for cash. QE will be reversed as those bonds mature, anyway. Raising Fed Fund rates and increasing rates paid on excess reserves addresses the goal more directly, with more control. The opportunity to earn a guaranteed increased rate on their excess reserves will make banks think twice about lending too much, and creating "too much" money in the system to quickly.

Counterintuitively, its interesting to note that interest rates ROSE, not fell, during all 3 periods of QE. So markets could very well move in the opposite direction once again as they react to a Fed bond sale this time around. Stranger things have happened! I don't think the Fed wants to try to outthink that.

Meanwhile...risk aversion continues as markets worry about Trump popularity (4 times bankrupt and threatening tariffs and trade wars) and a criminally wounded Hillary. She's turning out to be a dud for Leftists. Investors on both sides of the aisle see little comfort in the upcoming election. America needs to cleanse its palate and start over.

Anonymous said...

The only problem the FRB has in raising rates is their fear the stock market will sell off.

Scott Grannis said...

Excess reserves total about $2.5 trillion. If the Fed eschewed raising the rate it pays on reserves, it would be nearly impossible for them to reduce the supply of excess reserves by enough, in the foreseeable future, to create a shortage of reserves. The only practical way to restrain bank lending is by increasing the rate the Fed pays on reserves by enough to make banks content to hold excess reserves and not use them to increase lending.

Over time, the Fed expects to reduce the amount of excess reserves by allowing maturing securities to run off, and by selling securities. But it will probably take years for excess reserves to fall to levels low enough to create a scarcity of reserves.

Benjamin Cole said...

Gadzooks...another warning about inflation?

The world has changed... the US economy has changed. Labor unions are dead, whole industries have been rate deregulated such as telecommunications, and transportation. Free trade is the norm. now. The US has global supply lines. Big Labor is dead, big auto is dead, big steel dead, big aluminum is dead. Top marginal tax rates have been cut from 90% to below 40%.

The Fed should consider a long-run QE program, as is the Bank of Japan. A reduction in interest on excess reserves is an interesting idea.

A permanent monetary noose on the neck of the economy for the glories of fighting inflation does not strike me as an attractive idea.

BTW--- if we wish to fight housing inflation we should increase housing supply. But when would Southern California coastal cities decriminalize robust housing construction?