Friday, April 20, 2012

By special request, here's a discussion of monetary policy and the economy.  For the last several years, some have warned that inflation will spin out of control because of QE1, QE2, and other forms of stimulus implemented by the Fed.  The basis for their argument is that the money supply is growing too rapidly and too much money is chasing too few goods, which results in high inflation.  So why hasn't inflation risen much above 3% in recent years?  One reason is that some are confusing the monetary base (which consists of bank reserves and cash in circulation) with the money supply (bank deposits and cash circulation).  The monetary base has experienced explosive growth since 2008, but the money supply hasn't grown nearly as much.  Since the collapse of Lehman Brothers in mid-Septmber, 2008, the monetary base has grown at an annual rate of 37%, but the money supply has only grown by 4.5% per year (though that has risen recently).  Why?  Because banks are holding onto a record amount of excess reserves (S1.5 trillion as of April 18, 2012).  Next, is there a chase taking place?  Going back to Irving Fisher, economists have made use of the equation of exchange to estimate this chase by multiplying the money supply (M) by the velocity of money (V).  How has this behaved over time?  The chart below estimates the chase by considering the percentage change in MV:


You'll note that it grew rapidly in the 1970s, resulting in inflation (as expected).  However, it dropped significantly during the recession and is still growing only modestly, thus suggesting that inflation is not a threat at this time.

What happens when banks start lending those excess reserves? Excess reserves declined by $100 billion in the second half of 2011, but have since stabilized.  If banks start loaning large amount of excess reserves, the money supply will begin to expand rapidly and inflation becomes a threat.  That's why it's critical for the Fed to have an exit strategy (which Ben Bernanke has explained on repeated occasions; for example, click here).  Having a strategy and executing it well is easier said than done.  In the mid-2000s, the Japanese central bank implemented QE and then withdrew it without igniting inflation, so it can be done.  On the flip side, how likely is QE3?  Bernanke has stressed that the primary rational for QE1, QE2, and a possible QE3 is to avoid deflation.  A sluggish recovery with moderate inflation doesn't justify QE3.  Barring another perceived (or actual) threat of deflation, QE3 would seem to be unlikely.

What's happening with bank lending?  Here's a table that traces bank lending in its many forms.  Commercial and industrial loans rebounded nicely in 2011, but real estate and consumer loans continue to languish.

The principles of monetary policy that existed prior to the Great Recession still appear to hold true.  Given that the money supply is not expanding at a rapid rate by historical standards and given that there's no chase, inflation is not a threat in the near term.  If conditions change and the Fed sits idly by, inflation could be an issue down the road, but this is unlikely to occur.  Executing the exit strategy will be difficult (too soon could stifle the recovery, too late could lead to higher inflation than desired), but chances are the mistake is likely to be relatively small, making high inflaiton unlikely.  On a related not, break-even inflation according to the TIPS market is 1.91% over the next 5 years and 2.19% over the next decade, suggesting that financial markets are not concerned about inflation any time soon.

Friday, April 6, 2012

March Employment Report

In recent posts, I've noted how the data has presented a mixed message about the economy with the job market indicating a strengthening economy while GDP and other data indicating a more sluggish economy.  Today's job market report suggests that previous job market reports were biased upward, probably due to seasonal adjustments and extra warm weather.  The report indicated that 120,000 jobs were created in March, down considerably from over 200,000 per month in recent months.  In addition, the unemployment rate declined to 8.2%, but this was due to more people leaving the labor force as the household survey (used to estimate the unemployment rate) showed a loss in jobs.  A more precise measure of the labor market is hours worked, which declined in March, led by declines in construction and manufacturing. 
What sectors led to the relative weakness in the job market?  Temp agencies added 55,000 jobs in February, but lost 7500 in March (a difference of 62,500, which accounts for a majority of the decline).  The rest of the weakness appears to be spread throughout other sectors, with slowdowns particularly evident in health care and information services.

Are there any positive news from the report?  Besides the decline in the unemployment rate, the broad measure of unemployment (U6) declined from 14.9% to 14.5%  This was mainly due to a decline in those working part-time for economic reasons.  As part-time employment fell, more people were working full time.

Rather than reflecting a significant slowdown in the job market, I think the report indicates limitations in the data, due to seasonal adjustments and unusually warm weather in many parts of the country.  As noted elsewhere, it's going to be hard for the job market to improve significantly unless economic growth also strengthens, which is not expected in the near future.

Sunday, April 1, 2012

Spending vs. Income

One of the reasons that many economists remain cautious about the ongoing strength of the recovery is the state of the consumer.  Two factors are expected to constrain consumer spending - deleveraging and modest gains in income.  On Friday, the government released the latest report on disposable income and consumer spending.  The headline numbers show that though disposable income rose by 0.2% in February, consumer spending rose by 0.8%, reducing the savings rate to 3.7%, the lowest since August 2009.  After adjusting for inflation, real disposable income actually declined slightly while spending rose by 0.5% (real disposable income has declined in 3 out of the last 4 months).  For all of 2011, real disposable income rose by 1.3% while spending rose by 2.2%.  The blog, Calculated Risk, has a brief discussion of the role of transfer payments in affecting personal income (note: transfer payments include government payments such as social security, welfare, etc.).  Real disposable income excluding transfer payments are still down 4.2% since the start of the recession.

It's hard to imagine consumer spending increasing at a high and sustained pace unless there's more significant gains in income.  The hope is that recent gains in employment will translate into income gains, but it's not showing up yet.  Thus, it's likely that growth in consumer spending is likely to be more subdued as 2012 progresses, thus limiting the pace of economic growth (note: it still signals continued economic growth).