A Recovery Unlike Any In Recorded Economic History

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The Europeans have a few months head start, having seen and experienced a negative "inflation" rate in December. For us in America, a negative CPI rate is exceedingly rare. Going back just to 1960, when Paul Samuelson and Robert Solow first introduced the policy idea of the "exploitable" Phillips Curve (and the Great Inflation shortly thereafter), there have been exactly nine months featuring a CPI below zero. Eight of those occurred in 2009 at the very bottom, very worst of the Great Recession. The ninth was January 2015.

There is an awful incongruity here as there is an almost reverse image between the Great Inflation and the period following the Great Recession. Some people, particularly economists, call it a recovery but it has not acted like any recovery in recorded economic history. The closest would be the reflation period from 1933 to 1937, but even then there was at least a tremendous amount of forward economic momentum, just not enough to dig out of the huge hole.

Whereas the Federal Reserve and monetary theory was looking at inflation as a tool in both periods, they only got in the former. By the 1970's, central banks all over were simply confounded by "too much" inflation when all they really wanted was "just enough" to follow Samuelson and Solow's advice. In the 2010's, the opposite case dominates, again globally, where central banks all over are simply confounded there isn't "enough" inflation to generate economic momentum.

This isn't for lack of trying, of course, as every major central bank on earth has been undertaking "extraordinary" monetary policies. This includes various and sundry versions of QE which intend to expand the "money supply" in order to "accommodate" banking and credit creation. At least that is the operative theory, where it is really expected that just the insistence of central bank durability in this area will "persuade" economic agents to act in anticipation of "inflation."

This is the core of rational expectations theory, whereby monetary economics assumes "rational" behavior as it relates to monetary policy can thus be fully effective. All a central bank must do is even threaten to be overly "loose" and thus "inflation expectations" will by their own adjust; in making such an adjustment in expectations, economic agents invariably create transactions that lead to further and generic economic activity. "Aggregate demand" is thus created from nothing more than central bank phantoms and the previously recessed economy winds its way back up to "potential."

It's all neat and tidy as if some bedtime story for children. However, as the CPI in the US and the HICP in Europe demonstrate (acknowledging, of course, that these are not perfect measures of "inflation" nor do they much correspond with the concept), something is very amiss. That would start, obviously, with the fact that "inflation" rates in both the US and Europe follow almost exactly the same path. If you plot the CPI (or PCE deflator if you are an FOMC member) against the HICP you will immediately observe that they are an almost exact match.

Apart from the Bank of Japan starting in April 2013, the ECB and Federal Reserve have been most active in creating bank "reserves", which is highly curious given the track of official inflation. Without giving it much thought, you might even begin to wonder if creating so much bank "reserves" in the first place is actually "deflationary" as the correlation is obvious and ubiquitous across geography (one can easily add the PBOC to this same mix, to account for the four largest economic systems on earth).

It's not as if this would be the first time monetary theory, especially in this post-1960 activist/statist format, got it all backwards. You can go through each and every FOMC meeting in 2007 and 2008 (and likely 2009 when they get released any day now) and see on full display how policymakers were not just wrong at every turn, but completely backwards in their assessments and even basic understanding of what was taking place and why. It wasn't just the case of being overoptimistic of economic resilience and their own part contributing to that ideal, but rather they kept looking in the wrong place as if what was important in 1970 was just as important in 2008.

The starting point for all this is the modern conception of "reserves" themselves. Even the Fed's academic side admits fully that there is no relationship whatsoever between levels of bank lending and bank reserves currently. That has not changed at all in the six plus years since the first QE in America. The week just prior to Lehman Brother's bankruptcy saw just $9 billion in total "reserve balances with Federal Reserve banks." As of the latest H.4.1 release, after four successive QE's, there are $2.45 trillion in bank "reserves" currently on balance.

In between those two points, "inflation" in the United States rose suddenly in 2010 and early 2011, and has been falling ever since. Coincident to that, despite trillions in euros in "reserves" being created by the ECB in SMP's, OMT's, LTRO's, covered bond "purchases", T-LTRO's and now QE (scheduled to begin in March), Europe's inflation measure has matched the US CPI step for step.

Fiddling through the FDIC's Quarterly Banking Profile (QBP), this divergence between bank reserves and actual lending is fact. Encompassing about 8,000 bank institutions' call reports, the QBR notes that cash balances at banks in the aggregate were largely falling, as a proportion of total assets, until the second quarter of 2006. That was, if you recall, the top in the housing bubble marked by not just peak credit production but also peak home construction and even a few sales metrics. From there until Q3 2007, which included the events of August 9, 2007, bank cash balances rose slightly in proportion to assets.

After Q3 '07, the upturn in cash turned to a torrent in Q2 2008 (Bear Stearns) and kept going right on through the bank panic itself. In terms of numbers, the QBP reports 3.8% allocation to cash in Q3 '07, 4.2% in Q2 '08 and an astonishing 8% by the end of 2008. In raw dollar terms, that was an increase of $613 billion! There is no mystery as to why there "had" to be firesales of assets, as liquidity was paramount at that time and it had nothing to do with bank "reserves."

What was in very short supply was wholesale funding, including repo and eurodollars. Now the QBP itself only describes the domestic banking end of everything, as the eurodollar market was both the center of the panic and largely was and remains unobserved. However, even with only good figures on the domestic side of the "dollar" there is enough to warrant both hard conclusions and inferences about the entire liquidity system.

At the end of Q2 '07, banks were reporting about $853 billion in federal funds purchased and repos (borrowed) compared to $575 billion in federal funds sold and reverse repos (lending). The remainder funding gap was likely supplied via eurodollar transfers and changes in cash holdings (which, to that point, were steadily declining suggesting strongly that eurodollar wholesale was the marginal funding source).

In the initial stages of the crisis, banks began to supply a huge increase in wholesale funding. Federal funds sold and reverse repos surged to a high of $748 billion at the end of Q3 '08, while the opposite end, uses of wholesale funds, grew to about $943 billion (we have to be careful here about these quarterly figures in that they are "window dressed" by banks at quarter end, meaning that actual activity in between may differ and differ by a large amount). Despite that proportional increase in wholesale funding available, banks still increased cash balances by an unheard quantity (at least since 1933).

Orthodox monetary theory assigns emotion a great deal of the blame here, and thus appeals to psychology as the fix. That is why, despite "leaving" total bank "reserves" at around $8-10 billion consistently throughout 2007 and 2008 up until Lehman, the Fed fully believed it could resist this tidal force of liquidity drainage through nothing but interest rate cuts and some half-hearted efforts at dollar swaps and collateral transformation.

If nothing else, the fact that the domestic "market" was willing to supply almost $200 billion in additional funds throughout the panic shows that interest rate cuts were for nothing but show. Banks were supplying those funds as "excess" because of the decline in their own interest in holding risky positions, and were only supplying them to domestic banks usually of the upper ends of the asset scale. That meant both a geographical funding divide as well as one by bank size, meaning higher effective interest rates in funding (like the LIBOR/federal funds spread that suddenly appeared and remained from August 2007 throughout) than were to be intended via the simple policy adjustments in the FOMC's federal funds target. Indeed, the effective federal funds rate in late 2007 and then again during the heavier panic in 2008 was consistently below the policy target as liquidity was not what policy thought it was.

But it wasn't just cash that was a symptom of liquidity. The QBP reports that holdings of US treasury securities increased by $166 billion between Bear Stearns' failure and the start of QE2 in Q4 2010. That increase came almost exclusive after 2008, meaning that banks were loading up on US treasuries at the same time the Federal Reserve was first busy creating "cash" through bank "reserves."

Credit creation (defined as the growth in total noncash/non-UST bank assets) averaged 9.4% (year-over-year) from 2003 through the end of 2007. That was the period where total bank "reserves" were almost always between $8-10 billion; a trifling amount. From the advent of QE2 forward, credit creation has averaged just 1.9% despite total bank "reserves" being below $1 trillion only in the first few weeks.

What has changed dramatically in the same direction as credit growth is wholesale funding. The amount of federal funds purchased plus repos peaked right at Lehman at nearly $1 trillion. By the time QE2 began, that total was down to just $614 billion; at the start of QE3, $495 billion; the latest figures for Q4 2014 show only $318 billion, or a total decline from the 2008 peak of 66%.

We know that wholesale funding in the eurodollar market is similarly impaired as that answers the constant and seemingly innumerable currency crises that have "appeared" ever since the taper selloff in mid-2013. That would include the Swiss National Bank's "surprise" undoing of the franc's peg to the euro, which was far more of a "dollar" funding problem than anything of euros or francs.

So we are left, in simple terms, where credit creation is very low where QE is very high, and thus "inflation" follows credit and not QE across both the US and Europe (Japan and China). What we cannot observe of the QBP or any of the aggregated figures, including those provided by the Federal Reserve for the banks under its watch, is any disparity including any that may be leftover and ongoing. If one of the most prominent features of the 2008 bank panic was this geographical divide between domestic wholesale dollars and those "dollars" outside, largely concentrated in London trading, who's to say that such a fragmentation has been erased or even alleviated to some degree?

The very framework of the practical application of QE favors exactly this size disparity. The Fed's New York Branch, where the Open Market Desk resides, "purchases" these bonds from primary dealers exclusively. They then depend upon these same primary dealers to circulate the newly created "reserves" far and wide, including any eurodollar deficiencies. There isn't any indication that either the primary dealers have an interest in doing so. In fact, judging by the QBP, larger banks are instead diminishing their participation in wholesale funding simply because it is not a necessary component with all these "reserves" sitting around idle.

The net result has been atrophy of wholesale funding that is far too apparent both domestically and internationally. Since wholesale markets act as a marginal source of liability trading, there is no discounting its importance to the liquidity profile of financial institutions all over the "dollar" system. There is a world of difference between a robust funding market driven by private concerns and one depleted by public intrusion and introduction. Just as the Fed and ECB have entertained this new modern role of "market of last resort" we cannot discount how much doing so changes the very character of international liquidity.

If banks are not assured of a steady liquidity market upon which to depend, then you can start to understand any reluctance to vastly expand "risk" and balance sheets. If the Fed intends that QE be inflationary it intends to do so through this credit-driven expansion. Thus, QE itself may be the very reason no such expansion has occurred (though it is important to keep in mind that the demand for credit overall also remains stuck close to zero as well).

That observation leads to the next stage that seems to be upon us, as the removal of QE and even ZIRP itself might then lead to the opposite state. In other words, if QE is actually a depressant on credit and thus "inflation", its end might fairly be expected to have the opposite effect. And that might be the case if QE was simply a neutral depressive force without any lasting impact, however as I have endeavored to describe persistently and probably redundantly for years, QE nor ZIRP are neutral. As the liquidity system in its current withered state shows all too well, the shrunken "market" for funding is as much a problem now as any further QE.

It was almost comical that over the weekend that Reuters reported surveying pension funds and banks in Europe about any plans to sell their bonds to the ECB once its version of QE becomes operational in March. To which many replied they have no such plans to part with their securities regardless of the price the ECB might bid for them. Part of that is regulatory, as new Basel-y rules are requiring a "liquidity buffer" of "high quality" bonds and securities remain in inventory for a given proportion of more risky assets. However, there is also the given reality of the current unstable environment.

Even in the US, banks have again taken to increasing their own "liquidity buffer" that is not related to regulations. As I have been saying for more than a year, there was a drastic shift in perceptions and activity in "dollars" and finance dating back to November 20, 2013. The QBP bears that out, as banks in the US have added an astounding $245 billion (one half again larger than what they did in during and after the panic) in US treasury securities since that time. We do not have to wonder who is bear flattening the yield curve, as it is these very banks themselves; institutions that are saying one thing in public about agreeing wholeheartedly with Janet Yellen and orthodox economists about the state of "markets" and the economy, but doing the exact opposite in practice.

So even in practical psychology, if there is such a thing, monetary efforts have come up short on all fronts. Banks not only refuse to expand into the "inflationary" paradise offered as monetarism, they are growing more and more pessimistic about the whole thing from funding on up. There is small wonder that "dollar" supplies in the world are "tightening", especially since late June when repo problems first started, leading to disruption in oil prices ("rising dollar") and thus the dreaded and rare appearance of "deflation."

If it were only as easy as simply ending QE and ZIRP, however the banking system and I will argue the global economy as a whole are worn down dramatically from having undergone them. Monetary policy is not neutral, at all, and it is distinctly observable in how it seems to always be backwards. The Fed and ECB want just a little inflation, but the harder they try to get it the further away we end up. In other words, since the modern "dollar" defies description and definition of the "money supply", using generic money supply policy ends up with unintentional results, like record stock prices and collapsing oil, currencies and yield curves.

 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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