Why It Is Going to be Whipsaw City, in the Second Half, for Most Economic Analysts

This is what I wrote on December 18, 2010 in a post titled, The Coming 'Sugar High' Economic Recovery:

As for the turnaround, it is totally a Ben Bernanke produced event, so it will be as manipulated of a "recovery" as one can get, followed by severe inflation. In other words, the economy will look good, maybe, for the first two quarters of 2011
and that's about it. I explained this to a D.C. insider who got it right away and said, "So it's going to be a 'sugar high' recovery." That nails it exactly.

As we come close to the end of the first two quarters that I wrote about back in December 2010, this is todays top headline at CNBC:

'Sugar High That Has Buoyed US Economy Is Wearing Out'

CNBC then quotes Mike Riddell, a fund manager at M&G Investments in London:

"It seems that almost every bit of data about the health of the US economy has disappointed expectations recently," said Riddell, in a note sent to CNBC on Wednesday.

Bottom line, most analysts are trend followers who forecast out the trend of the former month. They have no theory to understand the twists and turns of the economy (Or they hold a convulted Keynesian theory that must confuse them even more).

Right now, the economy is in an extremely vulnerable state that can result in it turning in a number of different directions. And few understand what even needs to be monitored. Whether there is a QE3,or not, is about number 5 on the list of monetary factors I am looking it. What happens to excess reserves, required reserves, seasonally adjusted money growth versus non-seasonally adjusted growth, the Fed funds rate versus the interest paid on excess reserves are all more important than if there is a QE3 (I monitor all these factors in the EPJ Daily Alert).

There are countervailing forces among these factors right now which make things trickier to forecast than ever. If there ever needs to be a time to monitor money factors very closely, it is the present. Otherwise, it is whipsaw city. All those watching Bernanke for an indication about QE3 are looking in the wrong direction. Bernanke is a mad scientist, who understands maybe half of the new tools he has created. As I wrote a week or so ago in an EPJ Daily Alert, Bernanke's QE2 is a scam. What you have to watch is the factors I outlined above, and the chief economist of financial research at the New York Fed, James McAndrews, has written an entire piece exposing Bernanke's quantitative easing nonsense and what needs to be monitored to understand what is going on in the economy. I reproduce from the the May 23, EPJ Daily Alert :

Long term EPJ Daily Alert readers know that I have been something of a
lone wolf advising that what needs to be watched is excess reserves
since Bernanke started paying interest on them rather than just Fed
assets. QE2 was kept largely under control from creating too much new
money because most of the funds went into excess reserves.

To my total amazement, the chief economist of financial research at
the New York Fed, James McAndrews, put out a report Monday, detailing
what has been my position right along, that QE2 did not have a greater
impact because the reserves went into excess reserves and they did so
because the Fed is paying interest on excess reserves.

I find that I am in nearly complete agreement with McAndrews
explanation, with the one caveat that he seems to believe that
reserves can be kept out of the system by controlling the rate paid on
excess reserves. True enough they can, technically. But the rate on
excess reserves is now 0.25%, if rates go back up to pre-crisis levels
of around 5%, I find it hard to believe that the Fed will boost rates
quick enough to the 5% level to stop the flow of some reserves into
the system. How many and at what speed will be the issue.

With that significant warning, McAndrews correctly makes the point
that QE2 was not that inflationary, but he neglects to emphasise that
now that QE2 is over, the excess reserve overhang remains and it has
the potential to become highly inflationary, even if there isn't a
QE3.

I reproduce McAndrew's full report below because of its major
significance in helping understand how Bernanke's new "tools" have
changed the game and monitoring monetary policy using pre-Bernanke
monetary watch posts, such as the assets on the Fed's balance sheet,
will lead to incorrect analysis.

Here's McAndrews:

Will the Federal Reserve’s Asset Purchases Lead to Higher Inflation?

By Jamie McAndrews

A common refrain among critics of the Federal Reserve’s large-scale

asset purchases (“LSAPs”) of Treasury securities is that the Fed is

simply printing money to purchase the assets, and that this money

growth will lead to much higher inflation. Are those charges accurate?

In this post, I explain that the Fed’s asset purchases do not

necessarily lead to higher money growth, and that the Fed’s ability

(since 2008) to pay interest on banks’ reserves provides a critical

new tool to constrain future money growth. With this innovation, an

increase in bank reserves no longer mechanically triggers a series of

responses that could lead to excessive money growth and higher

inflation.

To follow my argument, think of the relationship between Fed asset

purchases and inflation in terms of a pipeline with several sections.

The first section of the pipeline relates to reserve balances. When

the Fed purchases assets, it pays for the purchases by creating

reserve balances. These reserve balances can put pressure on later

sections of the pipeline—the money supply and inflation rate. Now,

however, there is a new valve—interest on reserves—that provides an

outlet from the pipeline to a reservoir, enabling policymakers to

reduce the pressure from reserves.

The Old Pipeline View: Why Fed Asset Purchases Will Generate Higher Inflation

There are three parts to the argument that Fed asset purchases will

lead to much higher inflation. First, there is the connection between

Fed asset purchases and reserves. When the Fed buys assets from the

public, it pays for them by electronically crediting banks’ accounts

at the Fed with reserves. Second, there is a connection between

reserves and money growth. When banks’ reserve balances increase, they

can use these additional reserves to make more loans to households and

businesses—an outcome that can lead to further growth in the broad

money supply in the economy. Third, there is a connection between

higher credit and money growth and inflation. For example, excessive

credit expansion can bring on higher money growth, excess demand

pressures, and overheating in the economy, which in turn can raise

inflation expectations and increase the inflation rate.

My view is that this description of the pipeline between Fed asset

purchases and inflation is accurate except for the connection between

reserves and money growth. I’ll show that asset purchases to date have

not led to unusually rapid growth in the money supply, and I’ll also

explain why a large amount of reserves need not induce rapid growth in

money over time.

A Useful Review: Money and Reserves

Money is usually defined as a generally accepted medium of exchange,

used to purchase a good or service or to retire a debt. Money takes

many forms in modern society, such as cash, deposit accounts at banks,

shares in money market mutual funds, and savings account balances and

other liabilities issued by banks, credit unions, and thrifts. The

Federal Reserve tracks two measures of money—the monetary aggregates

M1 and M2. Currency and demand deposits at banks are the largest

individual components of both M1 and M2, but M2—the broader

measure—also includes savings deposits, small time deposits, and

retail money funds (for fuller definitions, see Federal Reserve

Statistical Release H.6).

Reserves are balances that commercial banks hold in accounts at

Federal Reserve Banks. When the Fed purchases assets from the public,

it pays for them by electronically crediting funds to banks’ reserve

balances at the Fed. Reserves are part of the monetary base, another

monetary aggregate tracked by the Federal Reserve. The monetary base

consists mainly of currency and reserves (for a fuller definition, see

Federal Reserve Statistical Release H.3). In contrast to currency and

demand deposits at banks, which can be held by anyone, accounts at

Federal Reserve Banks can be held only by banks and a few other

special institutions such as the government-sponsored enterprises

Fannie Mae and Freddie Mac.

An important change in the nature of reserve balances occurred on

October 9, 2008, when banks began to earn interest on the reserve

balances they held at Federal Reserve Banks. As we shall see, this

transformation of reserves from a non-interest-bearing asset (like

currency) to an interest-bearing asset is significant.

With these concepts understood, we can now address our main

question: Will the Fed’s asset purchases lead to inflation?

How Do Fed Purchases Affect the Money Supply?

My counterargument to those who contend that Fed asset purchases will

generate higher inflation will focus on the second section of the

pipeline—the possible link between reserves and growth in money. When

the Fed purchases a security from the public, it first credits the

seller’s bank with reserves. In turn, the bank credits the seller’s

checking account with a deposit. As long as the seller does not

withdraw the deposit, the money supply, measured by either M1 or M2,

will have increased by the exact amount of the Fed’s purchase. It is

important to note that in the example just given, the money supply

increased because of the behavior of all parties: the Fed in creating

reserves, the bank in creating deposits, and the depositor in

maintaining the deposit.

In other circumstances, the increase in the money supply following

a purchase by the Fed can be either less than or greater than the

amount of the Fed’s asset purchase. If the depositors in the economy

are deleveraging, that is, if they choose to repay debts (such as

previous loans) after the bank credits their accounts with deposits,

the increase in the money supply following a Fed purchase can be less

than the amount of the Fed purchase. As a depositor repays a debt it

owes to a bank, the bank’s loans and deposits decrease. If depositors

are repaying loans at the same time that deposits are increasing as a

result of asset purchases by the Fed, then the net effect could be a

decrease in deposits, if the repayment of loans exceeds the asset

purchases.

Alternatively, if bank customers demand new loans from banks, and

banks use the reserves created by the Fed to extend loans to

customers, then the money supply could grow by more than the amount of

the Fed purchase.

What has, in fact, happened with the money supply since the

beginning of the LSAP programs in late 2008? As measured by the growth

in M1, money growth has been less than the amount of the Fed’s

purchases (see chart)—a development that is consistent with the

deleveraging, or net repayment of loans, by bank customers that has

occurred since late 2008. The Federal Reserve Bank of New York’s

Quarterly Report on Household Debt and Credit for the first quarter of

2011 indicated that “as of March 31, 2011, total consumer indebtedness

was $11.5 trillion, a reduction of $1.03 trillion (8.2 percent) from

its peak level at the close of 2008Q3.” So deleveraging by U.S.

consumers has been substantial during the period of the LSAPs.

The New Pipeline View: Why a Surge in Money Growth Isn’t Inevitable

As of early 2011, there was little evidence of aggressive lending by

banks, and the recent behavior of the broader money supply, economic

activity, and inflation suggests that money growth has not been

excessive. Nevertheless, there are commentators who view the high

level of reserves resulting from the Fed’s asset purchases as

“inflation tinder.” Won’t those reserve balances inevitably lead to

high money growth at some point, as banks seek to lend them out? Here

I can clearly state that the answer is no.

The basis for my answer is that the introduction of interest on

reserves has altered the linkage between reserves and money growth.

Before banks were eligible to earn interest on their reserve balances,

they had strong incentives to avoid holding “excess reserves”—reserves

in excess of the amount they are required to hold by regulation. High

levels of excess reserves in the old regime would be expected to

generate a high growth rate of loans, and consequently high money

growth whenever the banks’ risk-adjusted expected return on loans was

positive.

In the new regime, the Fed can vary the rate of interest on

reserves to directly affect banks’ incentives to lend out excess

reserves. For example, a bank holding excess reserves will not have an

economic incentive to lend out those reserves if the risk-adjusted

expected return on the loan is below the rate the bank earns on its

reserve balances. In terms of our analogy to a pipeline, the rate of

interest paid on reserves now acts as a valve, reducing the pressure

that Fed purchases might place on banks to increase lending and

thereby spur money growth. When higher interest rates are paid on

reserves, the reserves are put in a sort of reservoir, relieving a

flow that could ultimately generate higher inflation.

In its December 14, 2010, statement, the Federal Open Market

Committee (FOMC) indicated that it “will employ its policy tools as

necessary to support the economic recovery and to help ensure that

inflation, over time, is at levels consistent with its mandate.” The

FOMC may choose future policies that result in faster or slower money

growth, but the presence of large amounts of reserve balances on

banks’ balance sheets by itself does not inevitably commit the FOMC to

a high future money growth policy. Instead, if Fed policymakers

believe that it is preferable to rein in bank lending and money

growth, they can raise the rate of interest paid on reserves and

thereby dampen banks’ incentives to lend out reserve balances.

In one of the most difficult environments, ever, to understand what is going on in the economy, most analysts aren't even looking at the correct data. It's going to get real tricky out there and the trend followers will get smashed real hard. Next up, they have no idea how hard price inflation is going to hit in the second half. Buckle your seat belt.