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November 20, 2009
Understanding the inflationary versus the deflationary forces out there is pretty important today. To understand this issue better, we’ve recently been digging into the Federal Reserve's "money printing/ZIRP" (zero interest rate policy) and how it may or may not be inflationary. Time will tell the full story, but we’re coming to the conclusion that (assuming the Fed isn’t run by blind idiots) their policies are not necessarily inflationary. At least not in a classic sense.
Since August 2008, the Fed has been printing money. First – in response to a total freeze up in short-term lending - it printed money to lend to banks and other financial market players. This was done through various “liquidity facilities” that have now worked themselves off as the market’s need for that liquidity has faded away. This fading of demand for Fed supplied short-term loans would have normally resulted in a natural decline in the Fed’s balance sheet. In other words, the Fed's balance sheet would have returned to its pre-crisis size of about $800 billion from the now bloated $2 trillion size. The money printed would have become un-printed.
However, as the facilities usage dropped off, the Fed announced their plan to purchase up to $1.75 trillion worth of securities – Treasury debt, Fannie and Freddie debt and the biggest segment, Agency-Backed MBS (mortgages). They are now left buying MBS securities and will be done in March 2010 (an extended deadline).
Where has all this money gone? The sellers of the securities received newly “printed” dollars from the Fed and then…after changing hands many times in between…the cash landed into bank accounts. Normally, with this surge in bank deposits (now earning near 0%), banks would be keen on lending the money out. They have not. Instead, the money is just sitting in “reserve” accounts on deposit with…none other than the Federal Reserve itself!
The $1 trillion+ so far has simply washed through the financial system and completed its circular route back to the Fed. This is what it means to provide liquidity to the system.
In more ordinary times, the "excess" reserves (only a small fraction of reserves are "required" by the Fed) would feed into new loan production. The typical fear is that a renewed demand for loans will meet up with this huge supply of excess reserves and we'll witness a serious inflationary fire. And, let it be said, we’ve never seen anything close to $1 trillion+ in excess reserves. So, why exactly is total bank lending down and why are the banks just sitting on these excess reserves?
The answer is surely a combination of low demand for loans right now and the banking system is aware of future losses on the horizon. But, perhaps most importantly, the explanation comes from a little known and quite new Fed tool of that allows the Fed to pay the banks interest on those excess reserves.
The late 2008 TARP legislation changed the game for the Fed and as a result, we don’t think inflation is imminent simply because of the printing of massive amounts of cash. This new Fed tool - paying interest on reserves- along with the large deflationary factors of unused labor (high unemployment) and idle industrial capacity (still only 70%) leads us to believe inflation isn’t the primary concern.
Here is some background information on the Fed's ability to pay interest on reserves that helps explain how it has changed the money printing game. Also, an article by PIMCO’s Paul McCulley discusses the misunderstanding that many investors have about the Fed's current policies.
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November 16, 2009 |
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The latest figures on retail sales for October came out this morning and we took a closer look. Below is a picture that shows October Retail Sales excluding the volatile “auto” segment as well as the very predictable “food” segment. This measures the most discretionary segments in aggregate.
This index has shown an average 5.7% annual increase for the past 15 years or so. You can see that following the very shallow flattening during the ’00-’01 recession, the acceleration in the growth rate of retail spending was pretty apparent. During this very cheap money period of mid-’03 to mid-’08, the annual growth rate of this measure of retail sales grew at about 6.5%.
Setting aside the proposition that part of the growth seen in retail sales for the period from ‘92 to ‘08 was also fed by increasing consumer credit, we certainly know that the acceleration from ’03-’08 was fed by even easier credit. That credit-fed boost is gone for quite a while, in our opinion. Actually, we wonder how much the reversal of credit will subtract from sales growth in the coming years.
After the violent “reset” that occurred during the second half of 2008, you can see that the growth rate of spending has been sub-par, at best. In fact, one would expect that in a V-shaped recovery – as clearly expected by investors today – we would have seen a more rapid pickup in growth - even more than past average growth rates. However, it is now showing a 3.7% annual growth rate. And this is during the recovery.
It would seem that this points to a subdued economic recovery in 2010.
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