Friday, 4 July 2014

Goodbye Fed (for now), Hello Banks: A Classic Boom Bust Cycle Now Being Added on Top of The Fed Bubble

Clearly, bank credit expansion cannot increase capital investment by one iota. Investment can still come only from savings.
Man, Economy, and State, Murray N. Rothbard 

U.S. Money, Credit & Treasuries Review (as of 25 June 2014)

On June 18th, the Fed decided to taper its monthly asset purchases further, from $45 billion a month to $35 billion starting July (my bold): 
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate. 
Since December last year, asset purchases has now been reduced by $50 billion a month, a decrease of 58.8%. As a result, combined with a higher base, the year on year growth rate of the monetary base is declining rapidly. At 24.2%, the growth rate is now a significant 15.2 percentage points lower than the 39.4% growth rate at the end of last year.

What repercussions will this tapering by the Fed have for the U.S. economy? 

Firstly, it could affect treasury yields. In 2013, the Fed bought $45 billion worth of longer-term treasury securities every month to help push down yields on government securities. During that year, the federal debt increased $919 billion, of which the Fed was the (end) buyer of about $540 billion, or just under 59% of the increase in debt. During the first half of 2014, the U.S. federal debt has been growing at a substantially slower pace in U.S. dollar terms compared to the first half last year; $306 billion increase from 31 December 2012 to 18 June 2013 vs $180 billion increase from 31 December 2013 to 18 June 2014. The Fed will have bought about $190 billion worth of longer-term treasuries as of June this year, which is more than the increase in federal debt (105.6% of the increase in debt to be exact). This helps explain why the Fed is indeed tapering: the need to monetize new debt is simply currently much smaller than it was last year. Therefore, at the current pace of both Fed purchases and increases in government debt, the Fed's role as the marginal buyer of treasuries is still intact and in this sense the tapering by itself should not push yields higher. 

Secondly, the tapering could affect the distribution of the newly created money, including its overall growth rate. Basically, the money supply increases through two main channels: banks issuing new loans and the banks and/or the Fed buying securities from parties other than banks. Last year illustrates this well: during the year, the M2 money supply increased by about $565 billion, of which banks created a modest (in a historical perspective) $115 billion, or about 20%. The rest of the increase in the quantity of money outstanding was made up largely of the U.S. government issuing treasuries with a bulk of these ending up on the books of the Fed as discussed above. As the Fed tapers, presumably in tandem with the U.S. government continuing to reduce its debt expansion, less new money is created in the process. This will first hurt those people and companies that have become accustomed to receiving the newly created money early, e.g. government contractors. How this process will go about is difficult to tell, but some sectors will be affected which will then again ripple through the economy and lead to changes in the distribution of money in one way or another. Also, unless banks compensate for this reduction in the money supply growth rate now being caused by the government and the Fed, the overall growth rate in the money supply could head downwards sharply and thereby bring the economy and the financial markets with it. As I've stated before, banks have indeed started to expand lending. More on this below. 


The M2 money supply growth rate compared to last year ended on 6.6% for the bi-weekly period ending 25 June, the highest since October last year and higher than the 6.3% average during the last 12 months. Bank Credit increased 4.6% on the same basis, up from a 4.0% growth rate two weeks ago and substantially higher than the 1.1% growth rate at the end of last year.

This substantial growth in bank credit, combined with an expanding growth rate of the money supply, suggests banks are indeed creating enough credit, and with it new money, to compensate for the reduction in the growth of government debt and the Fed taper.

During the last 12 months, bank credit expanded by about $475 billion, or 4.6%. Where did this growth come from? Bank credit consists of two main items; Securities and Loans & Leases. Of this $475 billion growth, about $91 billion (19.1%) was due to an expansion of Securities held by banks while the rest, $384 billion (80.9%), was from an increase in Loans & Leases.

As Loans & Leases consists of Commercial & Industrial Loans, Real Estate Loans, Consumer Loans and Other Loans, each category's share of bank credit growth during the last 12 months can be broken down as follows:

Loans & Leases, which currently makes up 73.3% of bank credit (securities makes up the rest, see table below), increased 5.1% compared to same period last year to record the highest growth rate for almost two years. Increased bank lending has therefore been the major driver of the bank credit expansion during the last 12 months...

...of which a 10.5% increase on last year in the issuance of Commercial & Industrial Loans has been the main driver, making up 43.3% of the growth in Loans & Leases (and 34.5% of bank credit growth) during the last 12 months. 

In short, the negative effect the reduced expansion of government debt and the Fed taper has on the money supply growth rate has been largely offset by a corresponding expansion of bank credit this year. Whether this will continue remains to be seen and will be monitored in this bi-weekly report going forward. This shift in how and where new money is generated will have implications for the structure of the economy. In the aftermath of the banking crisis in 2008 and 2009, the money supply expanded predominantly by way of deficit spending: the government issued debt (monetized partly by the Fed) and spent those money in the economy. The trend now is that the bulk of the new money is generated through the conventional channel, namely the banks, of which a bulk ends up directly with corporations that then spend these new money. As a result, those who previously received the new money first will now lose or gain less than they have in recent years in terms of spending power while the new receivers of the new money generated by banks will increase theirs.

Finally, with reserve balances, most of which classified as "excess reserves, approaching $2.7 trillion, banks are in a position to greatly increase lending (ignoring other constraints such as qualified borrowers and the demand for credit). As they now appear to be doing just that, not from prior savings but from issuing new money (Cash Assets at banks are still increasing even as lending grows) the U.S. economy is now well on its way to discover the full force of the classic meaning of the Austrian Business Cycle Theory: an increase in the quantity of money generated by bank lending to corporations. If the growth in bank credit fueled by a growth in lending not backed by a commensurate amount of prior savings continues to push the money supply growth rate up, another artificial boom could be on its way. Perhaps that is what the U.S. stock market has noticed, or is anticipating, as it keeps hitting new record highs again this week. If that turns out to indeed be the case, the economy is now building up to a spectacular bust (even worse than the one which has been in the pipeline for years) which will make the previous one look like a walk in the park. Why? Because this time the U.S. government is seriously indebted to which can be added that the U.S. economy is much more dependent on government spending now than some six years ago. Also, bank balance sheets are no more solid now than pre Lehman: on 10 September 2008 the equity to total asset ratio for all U.S. commercial banks was 10.62%. Today it is 10.89%. Yes, banks hold a lot more cash this time, both in total and as a percent of total assets. But with the Fed always ready to bail out banks, it perhaps makes little difference if bank assets consists of mostly cash or treasuries (or MBSs) exchangeable for cash immediately at the sign of liquidity problems.


Key U.S. monetary statistics as of 25 June 2014 (treasury yields as of 2 July 2014):