Saturday, October 28, 2023

Growth and inflation update: not much to worry about

The big news this week—though widely anticipated—was the 4.9% annualized growth of the economy in the third quarter. Analysts still infected by Phillips Curve thinking worried that a strong economy would encourage the Fed to keep rates "higher for longer," thus posing the risk of a recession next year. (Note: economic growth does not cause inflation. In fact, over the past year the economy has continually beat growth expectations, all the while inflation has been declining rather significantly.) By week's end, worries about Middle East tensions trumped growth fears, and inflation data showed that disinflation, not inflation, remains the order of the day. Interest rates backed off their highs, and equities traded lower. Expect Phillip Curve nightmares to continue to haunt the market this coming week. As for Middle East tensions, well, that merits concern but I don't know of any obvious solution to that.

Chart #1

While 4.9% growth in one quarter certainly stands out as a big number, it's worth noting that it's an annualized number. In fact, the economy reportedly grew only 1.2% in the third quarter. And as Chart #1 shows, the path of real GDP (blue line) experienced only a small wiggle to the upside with this latest number, and it will probably experience a much smaller wiggle next quarter. The big story with GDP is that the economy has been growing by more or less 2.2% since mid-2009. That's a lot slower than the 3.1% trend which prevailed from 1965 through 2007. Today, the U.S. economy is unfortunately not in danger of growing too fast. It is just muddling along, fighting the headwinds of very high tax and regulatory burdens aggravated by excessive government spending on transfer payments and "green" energy boondoggles (green energy needs subsidies to compete since it's woefully inefficient).

 Chart #2

Chart #2 shows the year over year change in the GDP deflator, which is the broadest measure of inflation we have. By this measure, inflation has fallen from a high of 7.7% to now 3.2%. 

Chart #3

Chart #3 shows the 6-mo. annualized rate of change of the Personal Expenditures Consumption Deflator and its core (ex-food and energy) version (note: the PCE deflator is a better measure of inflation than the CPI because the weights of its components change dynamically as consumer habits change). Over the past six months both of these measures show inflation rising at a 2.8 - 3.2% annual rate, only about 1 percentage point faster than the upper end of Fed's target. 

Chart #4

Chart #4 breaks down the Personal Consumption Deflator into its 3 main categories. Note the impressive decline in durable goods prices which began in 1995, the year China first opened its economy to world trade. Most of the increase in inflation in recent decades comes from the service sector, which in turn reflects mostly wages. The huge increase in wages alongside a significant decline in durable goods prices means that an hour's worth of work today buys more than 3 times as much in the way of durable goods as it did in 1995. We've never before seen such an increase in purchasing power; prior to 1995, durable goods prices never declined on a multi-year basis.

Chart #5

Chart #5 shows real and nominal yields on 5-yr Treasuries and the difference between the two (green line), which is the market's expectation for what CPI inflation will average over the next 5 years. The rise in yields over the past 18 months has been driven almost exclusively by the rise in real interest rates. Real rates, in turn, are the best measure of how tight monetary policy is. Thus, tight money (as measured by a 340 bps rise in real yields) has brought inflation expectations down to about 2.3%, which is almost exactly the upper bound of the Fed's target for PCE inflation (2%), because the CPI tends to exceed the PCE deflator by about 30-40 bps per year.

Chart #6

Chart # 6 compares the level of real yields on 5-yr TIPS to the 2-yr annualized growth of GDP (which I use because it smooths out the random quarterly variations in actual GDP growth, and it likely mimics the public's perception of what current GDP growth is). Real yields tend to track the strength or weakness of the economy; high real yields prevailed in the late 1990s when the economy was exceptionally strong (growth rates of 4-5%), and real yields have been low during most of the past decade as the economy has averaged 2% annual growth. With the exception of the past 18 months, of course, when real yields have surged. If the economy remains on a 2.2% growth path, it wouldn't be unreasonable to expect that real yields will decline significantly from today's 2.4% levels. That would likely coincide with a relaxation of the Fed's monetary stance, and that, in turn, would provide welcome relief to the market.


Andrew said...

Thank-you Scott;

I do wonder if it's too late or not for the FED to cut rates.

It's unfortunate that the FED has a tendency to be late.
I know you've called for the FED to cut rates a while back.
However, the CME Futures market tool shows that a cut is not expected until June 2024.

Salmo Trutta said...

Dr. Daniel L. Thornton, Vice President and Economic Adviser: Research Division, Federal Reserve Bank of St. Louis, Working Paper Series

“Monetary Policy: Why Money Matters and Interest Rates Don’t”

“the interest rate is the price of credit, not the price of money”

“Today “monetary policy” should be more aptly named “interest rate policy” because policymakers pay virtually no attention to money.”

The composition of the money stock has undergone a huge change during C-19. The percentage of transaction deposits to gated deposits has risen 49%

Scott Grannis said...

Andrew: Yes, the market does not expect a cut until June. But I think there’s a decent chance they cut before then, and if they do, it will be a market-moving event. Even if the market just realized that a cut is coming sooner, it would be a big positive for risk assets. The opportunities are usually to be found in situations in which market expectations are likely to be proven wrong.

wkevinw said...

I am guessing next year we will have some kind of shallow recession- maybe two quarters of negative gdp, and they will officially call a recession. The fed cuts rates, and an expansion (weak) begins. Definitely ~4 years of stagnant economy.

The stock market is down something like 20-40% in real terms depending on which index you use, whether you include dividends, etc. Small caps are down about 40%, which is significant.

Passive 60/40 portfolio is down about 30% in real terms. Also significant.

If history is a guide, there will be a lost decade in stock prices; often more like 15 years, where the market climbs back to near or just over its all time highs, and sells off; multiple cyclical/small bear and bull markets- on a journey back to the 2022 highs/(to "nowhere").

Adam said...

The main reason I see: deglobalization, political instabilty leading to fly to save assets.Any other reasons?

Benjamin Cole said...

Commercial real estate, offices, might have a tough slog ahead.

But this is a great wrap-up by Scott Grannis. I always feel re-grounded in my understanding of the US economy after reading these blogs from Grannis.

I hope the Fed stays calm, maybe even holds onto its balance sheet.

A couple years of moderate inflation won't kill us, and tight labor markets are a tonic for social tensions.

Scott Grannis said...

Sure looks like things are going my way these days. The recent equity rally has been driven by the dawning realization that the Fed won't have to raise rates again. The next phase will involve expectations of a cut in rates. The market is not expecting a cut to happen before next May or June. I don't see why it can't cut sooner.

Larry said...

Thank You, Scott
You are a big help to me and I am sure many others over the years.
Please keep up the blog!!

Richard H. said...

Ok, I am going to go out on a limb and say Scott is wrong. Assuming no recession, I do not think long term interest rates will go down much more (i.e. this little reduction the last few days maybe all there is).
The excess money supply (the 6% long-term trend growth rate Scott has spoken of many times) that has regularly found its way into expanded asset values cannot continue indefinitely (i.e. the expansion of PE ratios). Moreover, with Federal deficits and the Fed no longer able to keep interest rates as low, these higher PE ratios will be harder to sustain. Instead this excess money supply will continue the recent trend of going into retail inflation, which will keep interest rates higher (and stock values staying the same, if not lower)
(my assumption here is that the "excess" amount of money supply is that amont over GDP growth, and that it has to go somewhere - asset value inflation or retail inflation)

Essential point: 6% money growth with 2% GDP growth is not sustainable without eventual inflation.

Vandy said...

With respect, I wouldn’t call 50 basis points (from nearly 5.0% to < 4.5%) over the past two weeks insignificant, Richard. But to your point, I don’t see a dire need for them to come down much further either. 4%-4.5% on 10 year treasuries are frankly normal and in my view, healthy.

Vandy said...

What’s not healthy are nearly $2 trillion deficits in a slow but steady economy

Salmo Trutta said...

The economy is being run in reverse. The solution is to drive the banks out of the savings business, i.e., reinstate Reg. Q ceilings. And that doesn't reduce the size of the payment's system, it simply redistributes money that was frozen by the banks.

Richard H. said...

Salmo, I don't understand why you say Bank savings are lost to productive use/consumption.
Can I lay out the mechanics?:
1.Bank makes loan
2.Bank creates deposit
3.Deposit is used by borrower, or to the extent not used, is paid interest on by the bank.
How is this deposit/money frozen in the banking system?
If, instead - under the scenario of taking Banks out of the savings business (the bank not paying any interest) - the borrower will take his money out of the bank and deposit it at a non bank. The bank must then transfer reserves to the non-banks' bank.
Losing reserves is a cost to the bank, just as paying interest to keep the deposit is a cost. What is the difference?
Either way the loan/money is not frozen (lost to productive use).
Where is my thinking wrong here?

Salmo Trutta said...

That's what everybody thinks. But the nonbank is a customer of some bank. So, the commercial banking system doesn't lose any deposits if money is transferred through a nonbank. There is just an increase in the supply of loan funds, but not the supply of money - a velocity relationship. I believe that's what is currently propelling the economy, the 2.1% nowcast, as a result of the increase in MMMFs balances.

And every time a bank buys securities from or makes loans to, the nonbank public, it creates new money somewhere in the system. It does not lend existing deposits. Deposits are the result of lending. There is no transference of ownership / exchange between counterparties of existing deposits. Of course, banks cannot operate unless they have a positive balance of payments.

Link Richard Werner:
Prof. Werner brilliantly explains how the banking system and financial sector really work. – YouTube

The DIDMCA of March 31st, 1980, was a ruse. It turned the nonbanks into banks. The justification for doing so was to stop the nonmember banks from leaving the system. Somehow legal reserves had become a "tax" [sic]. No, reserves were "Manna from Heaven", costless and showered on the system. The "money multiplier" was constructed from reserves (which apart from Friedman's "base", excludes currency).

link: Bank Reserves and Loans: The Fed Is Pushing On A String” - Charles Hugh Smith

Member bank transaction deposits had fallen to 65 percent of those in the system. So, monetary control became an issue.

But now Powell has eliminated required reserves. And monetarism has never been tried.

As I said: The only tool, credit control device, at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be properly controlled is legal reserves. The FED will obviously, sometime in the future, lose control of the money stock. May 8, 2020. 10:38 AMLink

Monetarism involves controlling total reserves, not non-borrowed reserves as Paul Volcker found out. Volcker targeted non-borrowed reserves (@$18.174b 4/1/1980) when total reserves were (@$44.88b). Paul Volcker stopped inflation by imposing reserve requirements on NOW accounts in April 1981.

The solution:

Salmo Trutta said...

The DIDMCA was a monumental mistake. It caused the Savings and Loan Association crisis (as predicted in May 1980) and the July 1990-Mar 1991 recession.

WSJ: "In a letter of March 15, 1981, Willis Alexander of the American Bankers Association claims that: 'Depository Institutions have lost an estimated $100b in potential consumer deposits alone to the unregulated money market mutual funds.' As any unbiased banker should know, all the money taken in by the money funds goes right back into the banks, in the form of CDs or bankers acceptances or other money market instruments; there is no net loss of deposits to the banking system. Complete deregulation of interest rates would simply allow a further escalation of rates by the banks, all of which compete against each other for the same total of deposits."

Written by Louis Stone whom the movie "Wall Street" was dedicated to - Vice President Shearson/American Express

Salmo Trutta said...

Link: Reserve Requirements and Monetary Control,requirements%20beyond%20member%20banks%20is%20not%20needed%20for

Link: Dr. Daniel L. Thornton, May 12, 2022:

“However, on March 26, 2020, the Board of Governors reduced the reserve requirement on checkable deposits to zero. This action ended the Fed’s ability to control M1.”

Salmo Trutta said...

The GOSPEL was formulated during the Great Depression. I.e., we knew this already:

In 1931 a commission was established on Member Bank Reserve Requirements. The commission completed their recommendations after a 7-year inquiry on Feb. 5, 1938. The study was entitled:

“Member Bank Reserve Requirements — Analysis of Committee Proposal”
its 2nd proposal: “Requirements against debits to deposits”

After a 45-year hiatus, this research paper was “declassified” on March 23, 1983. By the time this paper was “declassified”, Nobel Laureate Dr. Milton Friedman had declared RRs to be a “tax” [sic].

It's politics, not economics, that has driven "innovation".

Salmo Trutta said...

Monetary policy should delimit all required reserves to balances in their District Reserve bank (IBDDs, like the ECB), and have uniform reserve ratios, for all deposits, in all banks, irrespective of size (something Nobel Laureate Dr. Milton Friedman advocated, December 16, 1959).

Salmo Trutta said...

"There are a number of noncontrollable factors that affect the money supply and tend
to weaken monetary control. One is shifts in the composition of deposits.",requirements%20beyond%20member%20banks%20is%20not%20needed%20for

This is why Scott Grannis' money demand is so important. There's been a big shift in the ratio of transaction deposits to gated deposits (as Dr. Daniel L. Thornton warned)

Richard H. said...

Hi Salmo,
I love reading you and trying to figure it out ... I think you probably know more about all this than almost anybody. How did you first get interested in the Fed, money, banking? I assume it was, like most of us, to try and understand the stock market ... but maybe not.
Ok, I have read much of what you reference here - and at earlier postings.
I know banks don't loan out deposits. But still I don't understand why the deposits banks create (from loans or securities) are not used productively. Aren't those loans/deposits used for consumption/production ..?

Salmo Trutta said...

I got interested in stocks when my Dad, whose an endocrinologist, had me buy Syntex (they invented the birth control pill). I got interested in banks because one of my Dad's friends owned a bunch of them.

I got interested in the FED in Dr. Leland Pritchard's money and banking class (Milton Friedman was one of his classmates at Chicago). Pritchard used to read his correspondence from Arthur Burns in class. Pritchard picked the top and bottoms of every market turn.

Pritchard wrote a column for Dr. Christopher Thomas, a cardiac surgeon (whose Dad was CEO of Gulf Oil). Thomas partnered with James Sinclair (whose father started the OTC stock market). Pritchard was a good friend.

Salmo Trutta said...

Werner's precepts are the closest to Pritchard's.

Link: Banks don’t take deposits. Banks don’t lend money. – Educated in Law - Richard Werner

Dr. Philip George's precepts are the closest to Scott Grannis'
Link: The Riddle of Money Finally Solved"

"For nearly a century the progress of macroeconomics has been stalled by a single error, an error so silly that generations to come will scarcely believe that it could have persisted for as long as it has done."

Salmo Trutta said...

re: "are not used productively"

The individual banker’s operative delusion stems from their everyday experience, that a bank’s lending capacity is increased when funds flow into the bank, which build up his bank’s clearing and correspondent balances (its legal lending capacity), and insofar as the funds are not required by law as a reserve against the incremental deposits inflow, can be used to buy securities or make loans. I.e., the lending equation, L = S(1-s), for a single commercial bank is comparable to a non-bank conduit.

The increased lending capacity of the financial intermediaries is comparable to the increased credit creating capacity of the commercial banks in only one instance; namely, the situation involving a single bank which has received a primary deposit and all newly created deposits flow to other banks in the system.

But this comparison is superficial since any expansion of credit by a commercial bank enlarges the money supply, whereas any extension of credit by an intermediary simply transfers the ownership of existing money.

Why are the time deposits not invested? Simply because the DFIs are carrying on their balance sheet a liability that is owned by the non-bank public. That cannot be used unless the nonbank public decides to use it, and by definition it is not being used.

Debits aren’t to the depositors’ accounts. Credits, ex nihilo, are to the borrowers’ account. The whole is not equal to the sum of its parts in the credit creation process.

Salmo Trutta said...

Every time a DFI makes a loan to, or buys securities from, the non-bank public, it creates new money - demand deposits, somewhere in the system.

Take the “Marshmallow Test”: (1) banks create new money (macro-economics), and incongruously (2) banks loan out the savings that are placed with them (micro-economics).

As Luca Pacioli, a Renaissance man, "The Father of Accounting and Bookkeeping” famously quipped: “debits on the left and credits on the right, don’t go to sleep with an imbalance”

You have to retain cognitive dissonance capacity, like Walter Isaacson described Albert Einstein’s ability: to hold two thoughts in your mind simultaneously – “to be puzzled when they conflicted, and to marvel when he could smell an underlying unity”.

By applying double-entry bookkeeping on a national scale, you'll find that the inputs and outputs to the commercial banking system are offsetting. Therefore, the funds created are endogenous.

As a system, the banks pay for the deposits that they already possess, already own. The drive by the commercial bankers, as perpetrated by the ABA, to expand their savings accounts has a totally irrational motivation, since it has meant, from a system’s perspective, competing for the opportunity to pay higher and higher interest rates on pre-existing deposits in the payment’s system. But it does profit a particular bank, to pioneer the introduction of a new financial instrument, such as the negotiable CD - until their competitors catch up; and then all are losers.

The question is not whether net earnings on assets are greater than the cost of the CDs to the bank; the question is the effect on the total profitability of the payment’s system. This is not a zero-sum game. One bank’s gains is less than the losses sustained by other banks. The whole (the forest), is not the sum of its parts (the trees), in the money creating process.

See the Fed’s propaganda in their own "Bible": by R. Alton Gilbert (retired senior economist and V.P. at FRB-STL) – who wrote: “Requiem for Regulation Q: what it did and why it passed away”, 2/1986 Review.

Dr. Gilbert asked the wrong question. His implicit and false premise was that savings are a source of loan-funds to the banking system. Dead wrong. All savings originate within, not outside, of the payment’s system. The source of time deposits (savings-investment type accounts), is other bank deposits, directly or indirectly via the currency route or through the DFI’s undivided profits accounts. And savings flowing through the nonbanks never leaves the payment’s system.

Gilbert assumed that any potential primary deposit (funds acquired from other CBs within the system, or derivative deposits), were newfound funds to the banking system as a whole.

Thereby in his analysis, Gilbert also assumes that every dollar placed with a non-bank deprives some commercial bank of a corresponding volume of loanable funds.

Gilbert asked: Was the net interest income on loans/investments derived from "attracting" these savings deposits (viz., outbidding other CBs), greater than the interest attributable to the direct and indirect operating expenses of retail and this wholesale "funding"?

Thus, the banksters victory (success at attracting funds from other banks) is Pyrrhic. The DFIs would be more profitable if they were driven out of the savings business altogether.

Duncan said...

PPI falls in October and up just 1.3% year over year. Scott is way to humble to take a victory lap, but he has been right as rain. The market is reacting to the "surprise" of lower inflation, but it was no surprise on these pages. It was predicted months ago.

Macronim said...

Re: "4%-4.5% on 10 year treasuries are frankly normal and in my view, healthy"

Nominal yields on 10Y US bonds were falling from ca. 10% in the 80' to ca. 2% just before the pandemics. Then they sharply increased because of higher inflaction expecations (and perhaps some other factors that I cannot indicate).

If the market expects inflation to average ca. 2.5% over the next five years (see chart no. 5 from the previous post of Scott), what would be the justification for nominal yields ranging 4-4.5% over long term?

Vandy said...


Because it’s averaged around 4% or so over the last 100 years.

Market and fed and Scott too probably aren’t right on inflation going down that low….too much debt requiring too much money circulation out there…nearly $2 trillion added just this year. Not a recipe for low inflation.