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United States
Revenge of the Ms
November 20, 2008

By David Greenlaw | New York

Unprecedented increase in excess reserves.  Beginning in mid-September, the Fed shifted to what economists call a quantitative easing approach to monetary policy. This move has resulted in a spike in excess reserves. In fact, excess reserves amounted to US$360 billion in the latest two-week maintenance period. Moreover, the recent announcement that the Treasury and the Fed would wind down the Supplementary Financing Program (SFP) means that excess reserves should rise by another US$500 billion or so over the course of the next couple of months!  The injection of such a massive amount of excess reserves in the US is unprecedented. In fact, prior to a few weeks ago, the all-time record for excess reserves was US$38 billion – and this occurred right after 9/11. The next highest was US$4.5 billion around the time of the Bear Stearns merger.  The long-run average stretching back to the early 1960s is US$1-1.5 billion.

Some background might be helpful. Banks are required to hold reserves against certain types of deposits. The Fed controls the quantity of reserves available to the overall system, and when the central bank acquires assets – without a corresponding offset somewhere else on their balance sheet – reserves are created (note: prior to mid-September, the Fed sterilised the impact of all the new assets it was acquiring by liquidating Treasury securities or taking other offsetting actions).

To this point, the bulk of the excess reserves created by the Fed in recent weeks have been hoarded by banks. In fact, over the same two-month interval that excess reserves have risen by US$360 billion or so, commercial banks’ holdings of cash assets have risen by about the same amount. This should not be too surprising. It is easy to see how it might take some time for the funds to be put to work. The only recent application of quantitative easing in a developed economy occurred from 2001-06 in Japan. And, according to our Japan economist Robert Feldman, it took several months before the approach started to gain some traction. In our view, the best way to monitor whether the extra reserves are starting to make their way into the US economy is to keep an eye on the money supply. 

In fact, for the first time in more than 20 years, money supply is starting to become relevant again. Money supply fell out of favour beginning in the 1980s as increased financial innovation began to cloud the whole concept of money. Money was easy to define in a world in which a consumer or business held their money in a passbook savings account or checking account. But as money market funds, Eurodollar CDs, repurchase agreements and other instruments started to gain popularity, it became much more difficult to define money. The Fed tried to keep up with the ongoing financial innovation by constantly redefining the money supply (anyone remember M1-b?). But eventually the Fed was forced to throw in the towel because the relationship between economic activity and all the alternative definitions of money broke down in a big way.

At that point, the Fed moved away from emphasising money supply and began to focus almost exclusively on the price of money – or short-term interest rates.   Turning to the current environment, with the fed funds rate now approaching zero, the Fed is moving away from an interest rate target and towards a quantity target. This means that quantitative measures of monetary policy – such as the money supply – are relevant once again.

Most importantly, in the present environment, movements in the money supply can be used to gauge the degree to which the excess bank reserves provided by the Fed are making their way into the broader economy.  It’s important to recognise that banks do not have to engage in making high-risk loans to individuals and business for quantitative easing to work. Any sort of expansion in bank credit – including conservative investments such as the purchase of agency discount notes – will start the process of money creation in motion.

How does the money creation process work? Basically, a rise in bank credit resulting from the creation of excess reserves (or ‘high-powered’ money) will trigger a corresponding increase in bank deposits and – via the fractional reserve accounting framework – second-round effects that involve a further expansion in bank credit.  For those who are interested, any undergraduate-level Money and Banking textbook (such as Ric Mishkin’s The Economics of Money, Banking and Financial Markets) will spell out the process of money creation in considerably more detail.

In simple terms, the relationship between the Fed’s balance sheet and the money supply is best understood using a measure known as the monetary base. The monetary base equals currency outstanding plus total bank reserves. Since the Fed handles the distribution of currency for the US Treasury (which prints it), and since the Fed manages the supply of bank reserves, the monetary base is under the control of the Fed. However, until very recently, the monetary base had little relevance for the financial system. This is because currency accounted for about 95% of the monetary base and Fed studies have determined that as much as three-quarters of the currency outstanding is held abroad. As a result, gyrations in the monetary base might have been a good gauge of drug trafficking and money laundering, but they had almost nothing to do with Fed policy or the domestic economy.  However, the recent spike in bank reserves means that the monetary base now has some relevance – especially in its role as a standard link to money supply.

The link between the monetary base and the money supply is the money multiplier. The Fed has only limited ability to influence the transmission of the monetary base to money, but the money multiplier is generally quite steady and predictable.  However, the money multiplier has plummeted in recent weeks, reflecting the fact that a massive quantity of excess reserves has been hoarded. The only time in history that the money multiplier has shown a sharp, sudden decline similar to that in recent weeks was during the Great Depression. In that case, the situation was a little different because the monetary base was expanding at a relatively normal pace, but the money supply was shrinking. This discrepancy between the performance of the monetary base and the money supply has contributed to some disagreement within the economics profession regarding the role of the Fed in the propagation of the Great Depression.

The Fed’s defenders point out that the central bank can control the quantity of bank reserves and the size of the monetary base, but has only limited ability to influence the money multiplier and therefore the money supply. Since reserves and the base continued to grow at a normal pace before and after the onset of the Depression, the Fed is not to blame. However, most modern-day economists argue that the monetary authorities simply should have pushed harder to expand reserves and the base in order to offset the decline in the multiplier and keep money supply from imploding. Is it any surprise that the Fed, led by an economist who has closely studied the Great Depression era, is now pushing excess reserves up in an unprecedented fashion?

In the latest weekly data reported by the Fed, M1 jumped a whopping US$44 billion. This follows on the heels of a US$33 billion jump in the prior week. Even on a year-on-year growth rate basis, the M1 aggregate has started to show signs of life in recent weeks.  By the way, we prefer M1 as an indicator of the impact of quantitative easing because it is most closely tied to bank balance sheets, whereas other measures like M2 or MZM include money market mutual funds and other non-bank deposits. But the growth of M2 has also shown a modest underlying acceleration in recent weeks. To be sure, all the monetary aggregates can be quite volatile and special factors such as the recent hike in the deposit insurance cap can lead to short-term distortions, but going forward we will be watching the growth in the money supply – particularly M1 – in order to gauge the effectiveness of quantitative easing.

QE, together with other policy measures already implemented and those now under consideration, represents powerful medicine. In fact, QE is aimed at restarting the intermediation of credit – which is precisely the objective of the bank recapitalisation initiative. Make no mistake, the US economy still appears headed for the deepest recession since 1982. However, macro policy is now moving in the right direction, and this should help to reduce the tail risk associated with an even more severe outcome.



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Global
Neither the Great Depression Nor Japan
November 20, 2008

By Joachim Fels | London

Our base case for the global economy remains pretty grim.  We think that this first synchronised recession in the advanced economies in more than 50 years will last at least until mid-2009, and emerging economies are slowing very sharply, too.  Headline inflation is likely to turn negative in the US and in the UK (on the RPI measure) next year and looks set to fall below target in the euro area.  However, we continue to look for an anaemic recovery to set in during 2H09 and 2010, and we do not believe that we will see a multi-year period of deflation (see Global Economics: Beyond a Deeper Recession: Tepid Recovery, November 10, 2008)

Yet, bearish investors are increasingly questioning our base case. Comparisons with Japan’s ‘lost decade’ of the 1990s or even the Great Depression of the 1930s have become quite popular.  Given the size of the shock to the financial sector and the recent sharp deterioration of economic indicators, this is understandable.  However, there are a few important reasons why we think that things will turn out to be neither as bad as in the Great Depression nor in the milder version of a depression that played out in Japan in the 1990s.      

Three policy mistakes in the Great Depression.   The Great Depression started out with a bursting asset bubble after a period of easy credit and irrational exuberance in the late 1920s that led to a recession. So much for the parallels. What turned the recession into a depression, however, with the US unemployment rate rising to 25%, was largely three major policy mistakes:

•           First, the Fed (and other central banks) stood by watching as one bank after another collapsed, and allowed a major contraction of the money supply. 

•           Second, fiscal policy was passive as governments tried to adhere to the balanced budget doctrine. Falling tax receipts thus led to cuts in government spending, aggravating the downturn in private sector demand.  This only ended when Franklin Roosevelt took office as US President in 1933 and created the New Deal.

•           Third, starting with the US Smoot-Hawley Tariff Act in 1930, a trade war began between the US and Europe, with governments raising import tariffs and thus choking off world trade. 

Today, policymakers are acting very differently, thanks to the lessons drawn from the Great Depression.   Following the collapse of Lehman Brothers, the regulators have made it clear that no systematically important banks will be allowed to fail.  Central banks have resorted to major monetary easing, consisting of a combination of much lower official rates and massive quantitative easing (see David Greenlaw’s piece that follows). Governments around the world are busy devising and enacting large fiscal stimulus packages. And, it appears unlikely that the world will see another trade war.  So, the reason why another Great Depression is unlikely is that today’s policymakers understand what went wrong back then and are eager not to repeat the mistakes of their predecessors. 

Also, a Japanese-type scenario is unlikely. If this is not the Great Depression, could it turn out to be Japan’s milder version of the 1990s?  After all, Japanese policymakers had the advantage of having studied the Great Depression and still ended up with a ‘lost decade’ of recurring recessions and (mild) deflation.  Again, we think it is different this time, mainly because policymakers in the US and Europe are doing already now, and in size, all the things that Japan did in a staggered fashion and partly with long delays:

•           After the equity and real estate bubble burst in 1989-90 and the economy entered recession, for many years banks were allowed to carry bad loans on their books without having to write them down.

•           The government only started to inject capital into banks in 1997, seven years into the lost decade.

•           Fiscal policy was stimulative, but the direct impact on effective demand was relatively small (less than 1% of GDP in most years), according to our Japan team.

•           The Bank of Japan only resorted to quantitative easing (QE) in 2001, more than 10 years after the crisis started.

By contrast, US and European banks over the past year have been busy writing down bad assets, governments have started to recapitalise banks, major fiscal stimulus is on its way and central banks are not only cutting interest rates but have started QE.  The monetary base (consisting of cash in circulation and banks’ reserves at the central bank) is currently growing at rates of 30-40% in the US, the euro area and the UK, and thus faster than in Japan in summer 2001 when the Bank of Japan started QE.  And importantly, as David Greenlaw explains in the note that follows, M1 growth (cash and sight deposits held by the public) has been surging in the US recently. We take this as an early sign that the monetary policy transmission process is starting to work again.   

Bottom Line

Again, it is important to emphasise that the G3 are in a severe recession that will last at least until mid-2009, possibly longer, and headline inflation will likely become negative at some stage next year in the US and Japan and drop below target in the euro area. However, the early and massive policy reaction will, in our view, prevent a replay of Japan in the 1990s or, worse, another Great Depression.



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