If Current Bank Credit Trends Continue, Bet Against the Feds Interest Rate Forecast
by Paul Kasriel
A majority of FOMC members currently expect that the interest rate on federal funds (immediately-available overnight funds), an interest rate targeted and controlled by the Federal Reserve, will not be increasing until late in 2014. If the current trend in the behavior of bank credit continues in 2012 and into 2013, I believe that the FOMC will be lifting its federal funds rate target early in the second half of 2013. Again, if the current growth trend in bank credit continues, a failure on the part of the FOMC to raise its federal funds rate target and shrink its balance sheet will sow the seeds of a rate of consumer inflation above the FOMCs 2% annualized target in 2014 and 2015.
Chart 1 shows the historical relationship between the growth in credit created by private monetary financial institutions (MFIs) i.e., commercial banks, savings and loan associations and credit unions and the growth in nominal gross domestic purchases of currently-produced goods and services. From Q1:1953 through Q3:2011, the latest complete MFI data available, the correlation between these two series is 0.65. This high correlation is no coincidence. Because of our fractional-reserve monetary system whereby private MFIs are required to hold only a fraction of the amount of their deposits as reserves at the Federal Reserve and/or as vault cash MFIs are able to, in effect, create credit (assets to them) and deposits (liabilities to them) figuratively out of thin air when provided seed money from the Federal Reserve. When the Fed purchases securities in the open market and/or lends funds to MFIs, it, too, is creating credit out of thin air. Because of our fractional-reserve monetary system, MFIs are able to multiply this Fed-provided seed money into a larger amount of thin-air credit and deposits. (If this sounds vaguely familiar, it is that money-multiplier exercise you had to learn in Econ 101 and relearn in Money and Banking.) Thin-air credit enables the recipients of it to increase their current spending whilst not requiring anyone else to cut back on his or her current spending. Thus, an increase in MFI, or thin-air, credit presumes a net increase in aggregate spending.
The same cannot categorically be said about non-MFI credit categories. For example, with one exception, when households extend new credit, they fund this new credit by cutting back on their current spending i.e., they increase their saving. As a result, there is no net increase in aggregate spending. In this case, the recipients of new household credit increase their current spending whilst households reduce their current spending. The one exception to this is when households fund their new credit extensions out of their deposit holdings. This is an example of an increase in the velocity of deposits, which, will lead to a net increase in aggregate spending. The correlation coefficient between percentage changes in gross domestic purchases and percentage changes in nonfinancial credit -- net credit advanced by households, nonfinancial businesses, state/local/federal governments and the rest of the world -- falls to 0.43. The correlation coefficient between percentage changes in gross domestic purchases and percentage changes in non-MFI financial sector credit credit extended by mutual funds, pension funds, insurance companies, broker/dealers, ABS issuers, etc. falls to 0.39. Moreover, examining the values of correlation coefficients when lead/lag relationships are tested between growth in spending and growth in credit extended by the nonfinancial sector and the non-MFI financial sector suggests that spending causes growth in credit in these categories rather than the other way around. That is, when growth in spending leads growth in credit for these categories of credit, the correlation coefficient increases significantly. When growth in these categories of credit leads growth in spending, the correlation coefficient declines significantly.
Chart 2 shows the recent behavior of loans and securities on the books of all U.S. commercial banks. Commercial bank credit accounts for the bulk of private MFI credit. As shown in Chart 2, bank credit grew at an annualized rate of 5.1% in the six months ended December 2011 compared to contracting at an annualized rate of 0.5% in the six months ended June 2011.
Coincident to this acceleration in bank-credit growth, there has been an acceleration in the growth of household aggregate demand. Chart 3 shows that real personal consumption expenditures grew at an annualized rate of 2.0% in Q4:2011 an acceleration in growth from the prior two quarters. Had the fourth quarter not been warmer than seasonal, real personal expenditures likely would have grown even faster. Excluding real spending on electric and gas utilities, real personal consumption expenditures grew at an annualized 2.7% in Q4:2011. Had real household expenditures on electric and gas utilities remained at the third-quarter level seasonally adjusted, all else the same, Q4:2011 real personal consumption expenditures would have grown at an annualized rate of 2.7% instead of 2.0%. Similarly, real GDP in Q4:2011 would have grown an annualized 3.2% rather than the reported 2.8%.
An important element in the acceleration in the growth of real personal consumption expenditures has been an increase in car/light truck sales. This past January, combined car and light truck sales ran at an annualized rate of almost 14.2 million units, edging out by a nose cash-for-clunker sales in August 2009 and the strongest monthly annualized sales rate since May 2008. For all of 2011, Detroit had its best sales year since 2008.
Households are starting to step up their purchases of homes, too, as shown in Chart 5. Why has it taken so long to develop some forward momentum in home sales given how affordable a home purchase has been in the last two years what with house prices falling both in absolute terms and relative to household income and extremely low mortgage rates? Perhaps it has something to do with the willingness of banks to grant mortgages at recent rock-bottom interest rates. As shown in Chart 6, banks evidently are more willing to extend mortgage credit inasmuch as growth in first mortgages on residential real estate has increased in recent months.
The recent acceleration in the growth in bank credit and household spending has translated into improving conditions in the U.S. labor market. One of the most reliable barometers of labor market conditions is the behavior of initial claims for unemployment insurance. These data are not blown up from a sample, but rather represent the universe of actual people getting in actual lines (or actually getting online to file their claims). Except for weekly seasonal adjustment factors, these are pure data. As Chart 7 shows, the number of people getting in line for the first time to apply for unemployment insurance benefits has been diminishing. So, the rate of firing has slowed, which typically is a prelude to an increase in the rate of hiring. And so it is again, as shown in Chart 8.
It is interesting that despite a sharp contraction in real government expenditures on goods and services in Q4:2011, 4.6% annualized, there was a 2.8% annualized increase in combined real expenditures on currently-produced goods and services by U.S. households, businesses and governments (local/state/federal) the fastest growth in these combined domestic expenditures since Q3:2010. As shown in Chart 9, this acceleration in the growth of total real domestic purchases just happened to coincide with an acceleration in bank credit (thin-air credit). This recent episode when the behavior of thin-air credit trumped the behavior of government spending and/or tax policies is consistent with prior episodes. For example, personal tax rates were increased in 1993 at the same time that growth in thin-air credit was accelerating. The behavior of growth in real domestic spending was more aligned with the growth in thin-air credit than it was with the behavior of fiscal policy variables. This is shown in the admittedly-complicated Chart 10. The blue bars in Chart 10 are the year-to-year billion-dollar changes in the cyclically-adjusted federal budget surplus or deficit. When the blue bars increase in positive territory, this means that federal spending has slowed or tax revenues have increased, adjusted for their normal cyclical behavior. In other words, when the blue bars move higher in positive territory, fiscal policy is getting more restrictive in a Keynesian sense; when the blue bars dip further in negative territory, fiscal policy is getting more stimulative.
This brings up the latest economic forecast by the Congressional Budget Office (CBO). The CBO is forecasting that Q4/Q4 real GDP growth will be 2.0% for calendar year 2012 and 1.1% for calendar year 2013. My comparable real GDP forecasts are 2.7% for 2012 and 3.7% for 2013. One important difference between my forecast and CBOs forecast is that CBO assumes that the tighter fiscal policies on tap this year and next significant federal spending cuts starting later in calendar 2012 and scheduled tax-rate increases at the beginning of calendar 2013 will retard real economic growth. In contrast, my stronger growth forecast is premised on the assumption of accelerating growth in thin-air credit, which, historically, has trumped fiscal policy changes. Although the CBO might excel in making federal budget projections, it is not at all clear it excels in making GDP projections. For example, in January 2008, the CBO was projecting annual average real GDP growth of 1.7% for calendar year 2008. In fact, real GDP contracted by 0.3% in 2008 vs. 2007 on an annual average basis. For that matter, the Federal Reserve was no better. In late January 2008, the central- tendency range of the FOMCs forecast for real GDP growth in 2008 on a Q4/Q4 basis was 1.3% to 2.0%. On a Q4/Q4 basis, real GDP contracted by 3.3% in 2008. As the most severe recession in the post-WWII era was commencing, neither the CBO nor the FOMC was forecasting it. For the record, the forecast I published early in February 2008 projected real GDP growing in 2008 by 0.7% on an annual average basis and contracting by 0.1% on a Q4/Q4 basis. Although I did not put it into the hole, I was closer to the pin than either the CBO or the Fed.
Collectively, the 27 nations of the European Union free-trade zone, aggregating to the largest economy in the world, appear to have entered a recession in the fourth quarter of 2011. Although I do not think the European recession will be a deep one, I do believe it will be a prolonged one. The Greek tragedy is different from the Italian comedy, but both have a negative impact on European banks inasmuch as these banks loaned large amounts to the Greek and Italian governments. As this is being written, negotiations are underway to determine by how much banks will have to write down the value of their Greek government securities. European banks will be capital impaired in 2012. As a result, European thin-air credit is likely to contract in 2012, which will keep Europe in a mild recession throughout the year. I do not anticipate a Lehman moment for the European financial system because the European Central Bank has aggressively engaged as a lender of last resort for the European financial system.
The third largest economy in the world, the Chinese economy, experienced a deceleration in growth in 2011. Now that mild CPI deflation has set in and real estate prices are falling, the Peoples Bank of China (PBOC) has the latitude to ease its monetary policy in order to accelerate growth in Chinese thin-air credit. In fact, it already has taken a step in that direction. With new Chinese political leadership taking over this year, the not-so-independent PBOC will want to make sure that Chinese economic growth is re-accelerating by the second half of 2012. The central banks of other growth economies, such as the Reserve Bank of India and Banco Central do Brasil, also have recently eased their monetary policies in an effort to re-accelerate their economies growth.
Because of the recession in Europe and the momentary slowdown in the pace of economic activity in the growth economies, U.S. exports will be stagnant in the first half of 2012, beginning to grow again in the second half as the growth economies experience a re-acceleration in the pace of their economic activity. The foreign sector, therefore, will present a headwind, but not a hurricane, for the U.S. economy. Continued growth in bank credit will provide more than enough power for the U.S. economy to make faster headway in 2012 than it did in 2011. Moreover, given that the CPI inflation that was present in the U.S. economy earlier in 2011 morphed into deflation by the end of the year, the Federal Reserve will turn its attention to bringing down the unemployment rate faster by enlarging its balance sheet via purchases of mortgage-backed securities, commencing early in Q2:2012.
I am an economist, not a geo-political analyst. But it is difficult for even an economist to ignore the rising risk of some kind of military engagement between Iran and Israel and/or the U.S. in 2012. If such a military engagement should occur, then the price of crude oil would initially spike because of a real or imagined interruption in the global supply of crude oil. Depending on how long the price of crude oil remained elevated, a global recession could occur. I deem this the biggest downside risk to my otherwise optimistic U.S. economic forecast for 2012 and 2013.
To reiterate, I believe that the Federal Reserve will begin cautiously raising its policy interest rates early in the second half of 2013 because U.S. real economic growth will be accelerating and inflationary pressures will be building. This forecast is premised on the expectation of continued and accelerating growth in bank credit in the U.S. along with another round of Federal Reserve purchases of securities that will expand the size of its balance sheet. Currently, I believe that the Federal Reserve will be forced to raise its policy interest rates aggressively in the first half of 2014 in order to forestall a significant acceleration in consumer price inflation. Remember 1994?
*Paul Kasriel is the recipient of the Lawrence R. Klein Award for Blue Chip Forecasting Accuracy
THE NORTHERN TRUST COMPANY ECONOMIC RESEARCH DEPARTMENT
SELECTED BUSINESS INDICATORS
Table 1 US GDP, Inflation, and Unemployment Rate
Table 2 Outlook for Interest Rates