Viewpoints

Are we there yet? Incoming information on the economy tells policymakers they have not achieved economic conditions (below-trend growth and slack in the labor markets) to ensure inflation continues to slow. And that spells bad news for investors because policymakers have indicated that slowing inflation alone is not a sufficient reason to prevent additional rate hikes.

At the July 25-26 FOMC meeting, policymakers stated that "a period of below-trend growth in real GDP and some softening in labor market conditions as needed to bring aggregate supply and aggregate demand into better balance and reduce inflation pressures sufficiently to return inflation to 2 percent over time."

Tightness in labor markets has lessened somewhat, but a 3.5% jobless rate in July tells policymakers that they are far from a situation in which there is enough slack in labor markets to limit wage and price pressures.

Yet, the economy's current growth performance is a more immediate concern to policymakers, especially after raising official rates over 500 basis points and expecting the lagged effects from higher rates to result in slower growth.

GDPNow, published by the Federal Reserve Bank of Atlanta staff, offers a running assessment of current quarter GDP growth. The GDPNow model uses much of the same source data that BEA, the government agency responsible for estimating GDP. But GDPNow differs from the old GDP flash report, which BEA prepared because it does not use detailed or imputed data in the official estimates, so it can overstate and understate growth for any particular quarter. Nonetheless, it has credibility since a Federal Reserve Regional Bank published it.

The latest estimate posted on August 16 shows Q3 GDP running at a 5.8% annualized rate, roughly three times above consensus estimates and far above what the Fed considers trend growth. The latest estimate only includes preliminary data for July, so two-thirds of Q3 economic activity is missing. Regardless of what's missing, it sends a message of strong and broad economic momentum in the early part of Q3.

Even if the final Q3 growth number ends half as fast as the August 16 GDPNow estimate, it should tell policymakers the lagged effects of when rising official rates run below inflation are much less, or even non-existent, as when rising official rates are above inflation. And the current stance of monetary policy is even less restrictive than advertised, given the level of QE.

So the level of official rates needed to slow the economy has yet to be reached, and whatever level policymakers or investors thought was appropriate should be raised by 100 basis points or more because of QE.

In this commentary I will explain the relationship between the shape of the yield curve, the behavior of nominal thin-air credit and the behavior of real aggregate demand for goods and services. Specifically, I will argue that there is a positive relationship between the “slope” of the yield curve and the percent change in thin-air credit. Further, I will argue that there is positive relationship between percent changes in real thin-air credit and percent change in real domestic aggregate demand for goods and services. For example, the steeper the slope in the yield curve, the faster will nominal thin-air credit grow. In turn, the faster will real domestic aggregate demand grow. The yield curve concept, I will be referring to is the spread between the yield on the Treasury 10-year security vs. the overnight federal funds rate (hereafter referred to as the yield spread). The importance of the federal funds rate in this yield spread will be explained later in this commentary. Thin-air credit for the purposes of this commentary will be defined as the sum of the asset categories of securities and loans on the books of depository institutions (currently, primarily commercial banks). “Thin-air” refers to the fact that the system of depository institutions has the unique ability among various other private lending entities to create credit figuratively out of thin air. (The central bank also has the ability to create credit out of thin-air. In fact, the central bank creates the “seed money” that enables the depository institution system to create thin-air credit.) The important implication of the ability to create credit out of thin-air is that the borrower can spend borrowed funds without necessitating any other entity to reduce its current spending. Thus, when new thin-air credit is created, we can assume that nominal current spending will increase, all else the same. (We cannot determine, a priori, what will be purchased by the borrowers of this new thin-air credit. It could be newly-produced goods and services or it could be existing assets, physical or financial.) We cannot make this same assumption when new credit is extended by non-depository entities. For example, if an individual extends credit, in order to fund that loan, she either has to cut back on her current spending or run down her current deposit holdings. If she reduces her current spending, i.e., increases her saving, no new net spending will occur from this loan because she will merely be transferring her spending ability to the borrower. If she funds the loan by running down her deposits, then there will be some net new spending in the economy. In economist jargon, this would be an example of an increase in the velocity of money. An increase in the velocity of money is another way of stating that there has been a decrease in the public’s demand for money balances. I am not aware of any statistic that measures total transactions in the US economy, transactions that include not only expenditures for newly-produced goods and services but also purchases of existing assets. So, I must rely on expenditures recorded in the National Income and Product Accounts (where the GDP data are reported). Because the bulk of thin-air credit created by US depository institutions goes to domestic borrowers, I have chosen Gross Domestic Purchases as my measure of aggregate domestic demand.

If you intend to read further, I would advise you have some Red Bulls on ice. It’s going to be a long one. Plotted in Chart 1 are quarterly averages of the level of federal funds rate (the blue line) and the yield spread between the Treasury 10-year security and the federal funds rate (the red bars). The gray shaded areas demarcate periods of recession. Notice as the federal funds rate declines, the spread tends to widen. Similarly, as the federal funds rate rises, the spread tends to narrow, sometimes going into negative territory. Why might this be, especially, why might the spread narrow when the federal funds rate rises? Remember, the Federal Reserve sets the level of federal funds rate. It does so by regulating the supply of cash reserves it creates out of thin-air in relation to the amount of these reserves demanded collectively by depository institutions (hereafter, banks). Prior to March 26, 2020, the Fed imposed reserve requirements on banks. That is, banks were required to hold as cash reserves (either on deposit at the Fed or as coin/currency in their vaults) in an amount equal to a specified percentage of their deposits. The Fed varied this percentage from time to time for reasons known only to the Fed. Prior to October 9, 2008, when the Fed began paying interest on reserves held by banks, these required reserves largely defined banks’ demand for reserves. If the Fed wanted to increase the level of the federal funds rate, it would reduce the amount of reserves it supplied relative to banks’ demand for reserves. Even if the Fed had not imposed reserve requirements on banks, they still would have had a demand for reserves. Banks would want to maintain a certain level of reserves to cover their clearings with other banks. As mentioned above, on October 9, 2008, the Fed began paying interest to banks on their reserves holdings. The reason it did so was to increase banks’ demand for reserves. In November 2008, the Fed began its first round of quantitative easing (QE), which added reserves to the banking system, but had not yet lowered its federal funds target to zero. In order to prevent the federal funds rate from falling to zero, the Fed induced the banking system to hold these extra reserves by paying them interest on their reserves holdings. Eventually, the Fed lowered its target for the federal funds rate to zero, yet the Fed continued to pay interest on reserves held by banks’ as it still does to this day. Why?

The Federal Reserve Bank of Philadelphia’s state coincident indexes in June increased from May in all but 3 states (New Jersey, Indiana, and Montana). Maryland and Washington were the leaders, and the only states with increases above 1 percent. Massachusetts (whose gain in June was just shy of 1 percent) had the largest 3-month increase, close to 4 percent—more than a percentage point above number 2 Maryland. In a sign that growth is cooling 28 states had gains of less than 1 percent in this period, including Montana’s small decline. Over the past 12 months, Massachusetts was once again the leader, with an increase of 6 ¾ percent, with Maryland a point behind (Bay Staters are likely fairly indifferent to that gap given the Orioles’ current lead over the Red Sox). Minnesota and Missouri had increases of less than 1 percent.

The independently estimated national figures of growth over the last 3 months (.73 percent) looks roughly in line of what the state figures suggest, while the corresponding 12-month result (3.50 percent) looks like it might be somewhat stronger than the state numbers.

The July 12, 2023, WSJ article, " Measure It Differently, And Inflation Is Behind Us," triggered a lively debate on housing costs in the CPI. The WSJ article argues that "no one pays" the rent used to measure owners' housing costs, so it should be overlooked or ignored. No one liked the results when BLS included "actual" housing costs based on prices, so government statisticians, academics, and politicians collaborated to change it.

So what is best, a CPI with no price for housing costs, a "fake" price, or an "actual" price? The answer is more than academic, as it will have significant implications for monetary policy and how the business cycle runs and ends.

The main opposition to including the price of a house in the CPI stems from the view that housing is an investment item, disqualifying it from inclusion in the consumer price index. Yet, the CPI has other investment items (e.g., watches, jewelry, etc.). But since the weight of those items is small, their inclusion is not controversial. So is the housing issue, the investment angle, or the weight in the index? It appears to be the latter, as "consistency" in measurement takes a back seat.

Critics also argue that people borrow money to purchase a house. So if the cost of a home, including financing costs, increases every time the Fed raises rates, housing inflation would rise, forcing the Fed to raise rates again and again. People borrow money and finance (credit cards, auto loans, etc. ) every good and service in the CPI, and these financing charges have significantly increased since the Fed raised the official rate. So why should housing financing be treated differently?

A consumer price index, including house prices, does not necessarily mean a higher consumer price index. The consumer price index will yield the same result if house price increases match other items' average growth. Only if house price increases were significant and persistent would there be an impact on the CPI.

The CPI, the government now publishes, has increasingly been enmeshed in the politics of the numbers. Printing a lower CPI than a higher one is more politically acceptable, even if that means including "fake" or "inaccurate" prices over actual prices.

With house prices living outside the standard price index nowadays, it is impossible to ascertain the aggregate actual inflation rate in the economy. That makes the Fed's job on price stability more complicated. That's because setting rates for a price index without housing risks the real cost of credit too low for real estate. Fifty years ago, Professors Alchian and Klein authored a paper, "On a Correct Measure of Inflation, stating " a price index used to measure inflation must include asset prices." Their analysis and conclusion are still valid today.

For a third straight month, the initial estimate of state labor markets for June had only 5 states sieeing statistically significant increases in payrolls, none appreciably numerically large. New York had the highest absolute gain (28,100) and Alabama had a .9% gain. Two states had statistically significant declines, with Indiana losing 13,900 jobs and Vermont recording a 1.4 percent drop (the other 5 New England states had insignificant declines).

11 states had statistically significant drops in unemployment from May to June (the same number as in May). Maryland’s .4 percentage point decline was the highest. Yet again, Nevada’s unemployment rate stayed the highest in the nation at an unchanged 5.4 percent. In another repeat from May, no other state had a rate more than a point higher than the national 3.7 percent, though DC’s was 5.1 percent. Alabama, Maine, Maryland, Montana, Nebraska, New Hampshire, North Dakota, South Dakota, Utah, Vermont, and Wisconsin all have rates more than a point lower than the nation, with New Hampshire and South Dakota both at 1.8 percent. California, Texas, Illinois, Washington, and Delaware (along with DC) are the states other than Nevada with rates at or above 4 percent.

Puerto Rico’s unemployment rate stayed at 6.1 percent. The job count on the island moved below 950,000. The bulk of the 8,200 drop was in the public sector.

The economy remains resilient and core measures of inflation are stubbornly high in the face of the most aggressive Fed tightening in decades. This resilience is partly a result of government stimulus programs during the COVID-19 pandemic. These programs generated a stockpile of excess savings that has continued to support household spending through rising inflation and higher interest rates. The Fed needs to counter that fiscal expansion in its fight against inflation.

Despite all the layoffs and furloughs, household income jumped during the pandemic due to the massive fiscal stimulus. Chart 1 shows the actual level of disposable personal income through the pandemic compared to trend. The income supports totaled more than $2 trillion in 2020-21. As the chart shows, the rise in income supports matched disposable personal income almost dollar for dollar.

State real GDP growth in 2023:1 ranged from North Dakota’s 12.4 percent annual rate to 0.1 percent in Rhode Island and Alabama. Growth was generally strongest in agricultural regions (though estimating the growth of farm output in the first quarter is always problematic). Northeastern states grew more slowly, in some instances in part due to weakness in agriculture, in others losses in manufacturing.

State personal income growth rates ranged from Maine’s 11.4 percent to Indiana’s -1.0 percent. As always, erratic swings in transfer payments account for much of the variation by state. Net earnings (employee compensation plus proprietors’ income) growth was strong in agricultural states, presumably due to a rise in farm income associated with the increase in agricultural output.

There is an economist in Chicago who has been known to see a silver lining behind every cloud. For example, after some natural disaster that resulted in hundreds of millions of dollars of damage to structures, this economist had been known to say that on the bright side, think of the rebuilding activity that will take place. By this logic, if the federal government wanted to increase the pace of economic activity, it could call on the US Air Force to carpet bomb some selected suburb, giving the residents plenty of notice to vacate the their premises with their irreplaceable possessions. (You might want to Google Bastiat’s “broken window fallacy” for the nonsense of this). I bring this up because after the debt-ceiling increase/extension legislation was signed into law on June 3, 2023, analysts, who unlike the aforementioned Chicago economist, see a cloud behind every silver lining. Even before the debt-ceiling bill hit the desk of President Biden, these nattering nabobs of negativity (you youngsters can Google this phrase) were saying that the rebuilding of Treasury balances at the Fed would suck liquidity out of the financial system, which, in turn, would cause all sorts of unspecified problems in the financial markets.

All else the same, it is true that an increase in Treasury deposits at the Fed would drain reserves from the banking system. But all else has not been the same in this case. Let’s go to Chart 1. Plotted in Chart 1 are the four-week billions of dollars changes in reserve balances held at the Fed by depository institutions (the blue bars), Treasury deposits at the Fed (the red line) and reverse repurchase agreements (RRPs) with the Fed (the green line). The last data points plotted are for the week ended June 28, 2023. In the four weeks ended June 28, Treasury deposits at the Fed increased by $360 billion, which, all else the same, would have drained that amount of reserves from the banking system. Yet, in the four weeks ended June 28, reserves at the Fed contracted by only $29 billion (the last blue bar plotted). Evidently, all else was not the same. One major factor that was not the same was the amount of RRPs executed with the Fed. An increase in RRPs drains reserves from the banking system; a decrease in RRPs adds reserves. In the four weeks ended June 28, RRPs executed with the Fed declined by $344 billion, which offset all but $16 billion of the reserves drained via the increase in Treasury balances at the Fed.