Credit impulse vs automatic x-leveraging


In this post, I want to argue briefly that Jason Benderly’s automatic deleveraging / releveraging framework is superior to Deutsche Banks’s notion of the credit impulse, even though the arithmetic involved in each concept is similar.

I won’t get into great detail here, because that would be tedious and because I don’t want to steal Benderly’s intellectual property.  My points here might be interesting to those of you who already have access to these approaches and wonder why they are sometimes deployed to support different macro outlooks.

For the rest, if this interests you, I suggest you get in touch with Jason at Applied Global Macro Research.  His deleveraging thesis was very helpful back when the bears were worried about deleveraging, before — for example — Bridgewater woke up, smelled the coffee and retroactively called it “beautiful.”  (Oops would have been more honest, especially from a firm favoring radical transparency.)

Incidentally, the timing of this post reflects JPM’s calendar-Q2 results and the contemporaneous upturn recently of bank lending growth.  It is not that there has been some meaningful inflection in the economy itself.

Ok, on to my simple point.

The main contribution of DB’s credit impulse perspective is to look at the right derivative, the one that correctly relates credit to aggregate demand growth.   The deleveraging bears wanted to look at the ratio of total credit outstanding to GDP, note that the line was going down, and draw dire implications from that.  DB corrected that wrong intuition with its credit impulse.

They pointed out (and still do) that the flow of aggregate demand supported by credit is determined by the flow of credit itself.  If that flow quickens, then the contribution to growth should quicken and — if you think credit is somehow determinative, which I don’t — nominal demand growth should speed up.

Closely related, if the flow starts off extremely depressed, then its quickening might leave the ratio of credit to nominal demand on a declining trend, and yet the contribution of the credit impulse can still be positive.

This ain’t rocket science, but doing the arithmetic here correctly can steer you away from some pretty big mistakes. The most costly mistake was the notion that deleveraging meant the rate of growth of credit-financed spending would be low.

One problem with the credit impulse perspective, though, is that it is too often presented as causal and leading.  For example, if the credit pulse is positive, then we should be bullish the economy and vice versa. That gets the causation wrong, IMV, and leaves some useful information on the table, which Benderly’s automatic deleveraging / releveraging perspective picks up.

For Benderly’s approach, let’s just focus on the deleveraging idea, which was probably the more helpful, although both were helpful. And then let’s just say that releveraging is the converse.

As mentioned, automatic deleveraging starts with a bit of arithmetic very close to the credit impulse approach. But it is fussier about relating credit growth to the components of aggregate demand that are actually credit-financed (basically all forms of investment). And more to the point, it gets causation right, by my lights anyways.

If the flow of spending in credit-intensive components of aggregate demand is currently at a depressed level, then we can make two forecasts. First, we can project, that the ratio of credit outstanding to nominal demand will continue to fall “automatically”, pretty much irrespective of the outlook for nominal demand growth.

Second and very closely related, we can then insist that there is no logical contradiction between a high-conviction view that deleveraging (as conventionally defined) will continue and an upbeat view on the economy. *  There is no need to wait until the credit flow data — measured as even as impulse  — have turned before getting upbeat.   This was the key advantage that Benderly had over DB.

That was then, and this is now.  In the current environment, credit-financed spending ** has recovered towards normal levels relative to the broader economy and so automatic deleveraging has predictably been replaced by releveraging.  I say “predictably” because I predicted it and actually mentioned to Jason that he might want to update his perspective to emphasize releveraging.  The student had learned from that master and had seized the pebble!

So US credit growth seems likely now to outpace overall GDP growth, for at least as long as investment (of all sorts) spending continues to track with GDP or slightly stronger, which probably means basically til the eve of the next recession.  I guess that is “good” if you are cheering for credit growth.

But it is no more bullish the economy than deleveraging was bearish.  In fact, to the extent that maintaining the flow of credit-intensive spending requires a bit more credit growth, if makes the economy slightly more exposed to any disruption in the flow of credit, from the supply or demand side.

I have suppressed here any discussion of the distinction between credit supply and demand — in order to simplify.  I have assumed that credit demand is largely endogenous to real-side developments, while ignoring supply, which — in fairness — has not been a major determinant of wiggles in the economy post crisis.  That could change obviously.  The discussion around it is a separate one left for another time, but it is not necessarily unimportant.

This post just goes over the difference between x-leveraging and impulse.  The latter seems to do the arithmetic properly, but the former has the additional advantage of getting the direction of causation right and is more helpful for forecasting.

* After the crisis, Benderly had an upbeat view of the economy, partly because of his insight into automatic deleveraging. And for the part of the economy where credit was relevant (and which the stock market disproportionately capitalizes) he was spectacularly right.  GDP growth was been held back largely by weakness in credit non-intensive spending, particularly during the early post-crisis period during which Benderly was pushing automatic deleveraging.

** This is more true of business investment than household outlays on housing and durables, which have recovered from their lows by briefly achieving quite strong growth, but remain fairly low in level terms by historical standards. I will update the relevant charts when I have access to more tech.

Generous interpretation of what Yellen up to


Bloomberg claims that Fed Chair Yellen’s “bet” that discouraged workers can be dragged back into the labor market with a high pressure economy is “paying off.”

I have nothing critical to offer on Yellen’s job performance, aside from maybe gently ribbing her for fibbing a lot.  But I think that argument is a bit too generous.

For starters, the labor force participation rate has not actually recovered much in response to Yellen’s alleged bet.  Probably it is up slightly on a detrended basis, but by the same token it is pretty near estimates, such as that produced by CBO, of its “natural” level.   Of course, CBO and others could be wrong.  (I am working with low tech here, so my charts will be even cruder than usual.)

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The Bloomberg journalist does not actually make a claim about the level of the participation rate, actual, detrended or natural.  Rather she shows a measure of the flow of workers from non-participation into employment.  Unfortunately, that measure does not support her main point, though.  The relevant metric here is the cumulative sum, not the number of months out of six that it had the right sign.

(Sorry to be grumpy, but Bloomberg — like BI– needs to impose a bit more quality control on their reporting, IMV. The purpose should be to inform, not confuse for the sake of novelty.)

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In any case, the Bloomberg claim would seem to be dominated on Ocham grounds by the simpler point that inflation is undershooting the Fed’s 2% objective.  If inflation were higher, I doubt Yellen would be making the “bet” attributed to her.

With inflation below target, the Fed is arguably forced into probing lower/tighter on unemployment.  I got no problem with that. What do I know?  The only points I would raise here are that it is a tricky situation for them, it is very unwise just to ignore inflation as “trailing”, and that we don’t need to lean on notion of exotic “bets”, though that may get clicks.

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Maybe more than 1 billion is too much

Let’s focus on the US, rather than the world, just to make this tangible. If you get it and like it, maybe you could figure out a way to imagine applying it globally.

Maybe it would be good if the US government were to seize every individual’s real wealth exceeding $1 billion and just destroy it.  I am not talking about trying to transfer that wealth through taxation, because that seems the easy case.  I am talking about actually destroying the wealth, in order to highlight the tougher case.

Such an approach (or one that rhymes) would make everybody poorer, as Tony Yates hinted at in a recent Tweet, which got me thinking about this idea again.  I concede Tony’s point (or what I am imposing as Tony’s point) as the first round effect, again just for the sake of argument.  But does that itself make the idea self-evidently dumb?

Destroying the wealth of the super-rich would reduce income/wealth inequality. This would bring two benefits. First, the lower end would feel less pain of envy, which would be an advance on your utilitarian metric, even though you may be loathe to accept that for ideological reasons that would say more about you than the argument. Pareto optimality is a sometimes-clarifying heuristic, not a Commandment.

Second, it is becoming pretty obvious that the super-rich are a direct threat to democracy.  Consider this dork, as just one example. He thinks what America needs is a second party committed to “capitalism”, and he means to buy it.

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Obviously, taking the wealth of the super-rich and just destroying it is not a first best solution.  It would be better if the Supreme Court didn’t see the right to distort politics as a fundamental speech right or if the median American were a little less easily fooled, etc. And as mentioned, even if you are neo-commie like me, taxation and transfer of real wealth would be better than destroying it outright.

Moreover, there are some downsides to my proposal, even if the alternative is simply not doing it.  Yes, my proposal reduces the freedom of plutocrats and would create a disincentive against accumulating wealth in excess of a billion. All who worry deeply about those put up your hands.

I am not sure if I even buy it myself. I probably do.  But dismissing a concern for income inequality per se as just muddled sentimentality is a muddled sentimentality — one that just happens to be widely accepted uncritically.  The virginal need to present and be accountable for an actual argument.

Financial sector in macro models

In the wake of The Crisis, which arguably got going in full force about a decade ago, there has been a lot of soul searching in macro academia over the role of the financial sector in the standards models.  It seems to be taken as a given, at least in some circles, that dismissing the financial sector as a mere veil delayed recognition of The Crisis and then stymied reaction to it.

I don’t have anything to offer on what progress has been made during the past decade or how much that has reduced the risk of a repeat.  My instinct is to be pessimistic on the old saw that humans won’t make the same mistake twice but will insist instead on making a brand new one.  The current clamor for financial deregulation to unleash animal spirits and “get the economy going again”, with unemployment below 4 1/2%, makes me grumpy.

But away from that, I would like to toss out an idea for your consideration that will either resonate or not.  I can’t hope to demonstrate my case here, because I don’t have the knowledge base.

It seems possible that the problem was not mostly with the macro models’ failure to understand the importance of bank and shadow bank balance sheets, contagion, the role of the financial accelerator, etc.  The problem was that many of us failed to identify the shock itself, which was a pretty big failure, but not one that can necessarily be put down to macro models.  Maybe Robert Lucas and Alan Greenspan lulled us into complacency, but it was through the spirit of the era, rather than through equations or lack of them.

I have mentioned this before, but I remember a colleague back at the old shop handing me an academic study going over the CDO Tower of Doom and the threat it posed to the economy. I also remember asking myself, how important could that be, compared with say, guessing what the Fed’s next move might be?  The study made such a little dent in my thinking that I cannot even remember its title. What I do remember is regretting not jumping all over it.

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In contrast, take a look at this very prescient and wonderfully unhedged piece of research from Jonathan Wilmot, published in August 2007, coming up on a decade ago.


Generously ignore the excessive emphasis on the risk of a sudden stop of international capital flows, which was common (e.g. Roubini) and ended up being sorely misplaced.  The problem was not that the supply of capital to the US was cut off, but that the demand for it evaporated, which is definitely a separate discussion. The proof is that the dollar spiked.

Focus instead on Wilmot’s emphasis on forced deleveraging and the risk that posed to real economic activity.   That ended up being extremely prescient. And for those with the wits to take it seriously and in real time, the presumed absence of a fully developed financial sector in the standard macro models was probably not really the issue.  Some guys were able to see this coming, despite it.

For another example of such guys, read or watch The Big Short. Focus on the scene where Brad Pitt explains to the greedy short sellers that they ought not be too happy, because the economy was about to melt and cause a ton of human misery. He did not get that from paleo, hydraulic, new or post Keynesianism, nor from classical or market monetarism.  But he had it, and without the advantage of hindsight.

Gone fishing

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Not really gone fishing. Just getting away from screens, hopefully for an extended period.

But here is a nice picture of the Margaree River on Cape Breton Island in Nova Scotia, where you could go fishing if you wanted. With any luck I will find myself near there soon.

Well, the Fed said

This post is ostensibly about how the Fed does not have its hair on fire about the declining unemployment rate and associated tightening of the labor market.  I will get to that extremely obvious point below, even at great risk of boring you.

But what this post is really about is how Fed watchers, including in academia, pay far too much attention – and deference – to what the Fed says, and don’t pay enough attention to what the Fed is doing or what is happening in the actual world.

We saw this in the extreme gullibility around the following claims, among others:

Monetary policy is “extremely accommodative”, whatever that means.

QE is a very potent tool, the use of which requires caution.

In a pinch, the Fed might do h money. LOL

Away from zero bound, policy will basically follow the logic of a Taylor Rule, although the unemployment coefficient and equilibrium real rate estimate are variable.

Inflation expectations are not too low. Rather, the invisible inflation risk premium in the bond market has fallen. And that decline of the invisible inflation risk premium is obviously not something policy needs to react to.

In fairness, there are two forms of gullibility operating here. The first is that the intellectuals believe the Fed believes what it says. And the second, is that they take they Fed’s word as authoritative. That’s the main issue. It is only the specific manifestation of the gullibility that varies.

Which brings me to what this post is meant to be about.  Recently Narayana Kocherlakota and Brad Delong have been complaining that the Fed is placing too much emphasis on the presumed establishment of full employment and not enough on the chronic inflation undershoot when setting policy.

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Kocherlakota and Delong both make the good point that the level of unemployment (or alternative measures of slack) consistent with full employment  is not well known.  Amen. I would add that there is some fuzziness around what the concept even means and how that relates to policy.  And Kocherlakota – bless him – sees straight through the nonsense claim that the bond market is basically pricing that the Fed will succeed in its stated objective. No it ain’t.

But these guys both pay far too much attention to the Fed’s claims about its intentions to avoid a potentially-destabilizing undershoot of the unemployment rate.

I think the Fed is probably right when it says that a steep decline of the unemployment rate below its “full-employment” level could be destabilizing, even if not accompanied by an immediate rise of inflation.  In my view, the Fed leadership is telling a coherent story here.

And the way they are managing that awkward trade-off seems sensible.  They are apparently trying to slow the tightening of labor market conditions, but not actually to stop it until they see evidence of a compelling inflation response.  This is a hell of a backward looking way to run a railroad, but it beats the others.

Importantly, then, they do not have their hair on fire about falling unemployment, whatever they might say.  The labor market has been tightening rapidly in recent months and the Fed is acting as though their intention might be to slow that rate of tightening, certainly not to halt it or reverse it.

The Fed leadership has made the judgment call that raising rates is required to achieve this moderation in the pace of tightening. Or at least that is my judgment of the judgment they are making. We don’t really know: I am just extrapolating ex post results from the past roughly two years of somewhat hawkish Fed talk.

But that’s sort of the point. We don’t really know.  Just because the Fed says they are doing something does not mean they are actually doing it? Let me turn this on you, dear reader. Do you think the Fed is acting to stop the decline of unemployment at some horizon relevant to policy decisions today, like Delong and Kocherlakota seem to assume they are?

One final thought. It occurs to me that I might be doing to Delong and Kocherlakota what they are doing to the Fed, that is taking their words too seriously. Maybe D & K know what the Fed is actually doing here, but are trying to swat down hawkish sounding Fed language before it has the chance to do real damage. If so, then it is me who the naïve one, not them.

But they are not important enough for me to do the Vulcan mind meld on. At their current level of influence, I am too lazy to go much beyond what they say, which seems wrong.


The debt debate is relevant now

Take a look at the chart below.  I suspect it might generate a couple reactions in many of you.

The first could be, wow those are some ugly colors right there.  Fair point. Green for go and red for stop is pretty cheesy.

The second might be, stop trying to scare the shit out of us: you sound like Larry Kotlikoff or –even worse — Stan Druckenmiller before Trump got elected and it was all ok for some weird reason.

But please bear with me. I am not one of those guys.  In my view, the US has plenty of fiscal capacity, and I was actually down with attempts at fiscal stimulus when the US economy was in liquidity trap, and stimulus would not all predictably be just offset by the Fed.

Screen Shot 2017-05-30 at 10.13.39 AMThe point of the chart is only to say that the question of fiscal capacity is relevant now, particularly with the US Congress debating whether to implement fiscal “stimulus” — to Fed rate hikes 😉 — which may or may not be be offset by cuts to entitlement programs.  We could easily imagine a combination of policy changes that would push the federal debt/GDP ratio to a record high within a decade. Is that ok? Opinions vary.

Some economists will tell you that this does not matter and that obsessing about the path of the debt/GDP ratio just reflects a misunderstanding of how the payments system works. For example, MMT holds that the US fiscal capacity is not limited by the size of the debt per se, although the deficit may need to be tightened occasionally if aggregate demand growth is running too hot.

An alternative, weaker-form, argument to which I subscribe is that the US has plenty of spare fiscal capacity. Any mistakes made today are not likely to cause immediate trouble, but would be unhelpful from a longer-term perspective.

Moreover, we ought not rely on the bond market “vigilantes” to warn us if we are acting improperly.  Among other considerations, the bond market might easily price the (contractionary) effects of eventually dealing with the deficit through orthodox means. The bond market vigilante story is not only stupid and demonstrably wrong, but it is also an affinity fraud.  “Clients” like to hear how heroic and important to society they are.

MMT seems right, then, that the bond market will not freak out soon, at least not over the debt.  It is just that the reasons for this — and the implication – are different from what MMT would describe.

We can reserve that important debate for another time. The purpose of this brief post is just to point out that this debate is currently relevant. It is not some abstract academic thing that looms 20 years out.

One caveat here is that my take on the importance of this issue is not falsifiable, which I readily concede is a big weakness.  If I am right about this, and if we get the ill-timed fiscal stimulus — to Fed rate hikes 😉 — anyway, it is easily conceivable that the bond market stays serene, with yields backing up only by enough to stabilize the macro backdrop in the short to medium term. That result would be consistent with both MMT and my take.

I am not sure what to do about that. In real time, which is what matters for policy implementation, this stuff is just not falsifiable, at least if my view of the world is right. [1] But I will have some speculations and argument about this later.

[1] If the fiscal alarmists were right, then the rising debt would trigger an immediate crisis in the bond market, followed presumably the need for a correction, which would be painful. But, fwiw, I share with MMT enthusiasts the view that those guys are nuts and/or totally full of shit about what they even believe. They have gone utterly silent since the election, predictably.


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Here is a picture of CBO’s long-term baseline, out to 2040. I did not want to go out all the way to 2040 in my simulations because I did not want to appear alarmist. We all agree that such runaway debt is unlikely to happen, which is actually the serious point I want to make.  If the debt cannot run away, then we need to consider now what that means for  policy and not just pretend that the “payments system” will make it all ok.

But this chart gives you a sense of the longer-term history. And unsurprisingly, the CBO forecast numbers look like my second highest simulation.  No additional fiscal ease; passive widening of the deficit in response to “demographics” and real rates back to the economy’s growth rate.

One final point, yes, there is great uncertainty around these numbers.  But if the base case is both fair and troubling, then I am not sure that symmetrical uncertainty around that would be a feature.


The prevalence of “and” in this note is less than 2%. Drop the mic.

Corporate stuff

I thought I would take a break from making fun of MMT, Trump and the human nature bulls to do some economics, which is probably too strong a term.

But here are a couple pictures based on the profits data included in last week’s revisions to the Q1 GDP figures.  In my view, bean counting the GDP add-up is mainly a waste of time, but there is some interesting stuff in the National Accounts.  How could there not be?

Here is the first thing to catch my eye, in part because I am inclined to look for it.   Early this cycle, real output from the domestic operations of nonfinancial corporations was booming, far outpacing the tepid recovery in overall GDP.  The GDP figures distracted a lot of equity types from the fact that the fundamental cyclical driver of profits was performing very strongly and was grounds for optimism.

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Margins went up too, which the bears were oddly inclined to dismiss as not really counting (WTF?), but margins are cyclical and responded to the output boom in the part of the economy that was not being held back by the aftermath of the housing bubble collapse.  I am still not sure if this simple historical point has been internalized, even by the bulls.

The thing is, though, that story is now very stale, as measured corporate sector output is now lagging the overall GDP.  I am not confident the lag will continue. But it does seem that the period of corporate outperformance is long past. Basically, we have already had the bounce in goods demand, driven by the renormalization (or partial renormalization) of all forms of investment, including in consumer durables.

Second and predictably related, profit margins have been coming down.  I am not a fan of margin mean reversion. To me it is more useful to look out the window at the cyclical drivers of margins and ask if they point up or down. Recently, they have pointed down, because we are past mid cycle, so I have looked for narrower margins.  But I would not have guessed – did not guess – that the compression would be this quick.

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Measurement is always an issue here. In particular, I would not be shocked if Brad Settler Setser – an expert in this area – were to point out that there is some goofy invoicing going on US corporate transfer pricing, which is holding down both measured exports and domestic profits.  One way to get around this would be to look at overall profits and not just domestic. But I am not sure what the denominator should be there.

Maybe I should do some simulations incorporating Setser’s estimates into the profit story. Sorry, too lazy. I don’t get paid for this. I doubt it would overturn the basic story. Maybe it would make these data look closer to what I would have guessed.  If you are getting paid to do actual work, get on it.

Separately, this has nothing to do with the cycle or market, but the fact that margins are back to the neighborhood of “average” gives me even greater skepticism that looking at the labor income share (which is supposedly depressed) tells us anything about anything, including income distribution.

The abstraction of “factors of production” may be a bit dated for the modern economy. If I wanted to be a dick, I would even say it is Marxist, but I am just your humble and objective analyst.

I may have more on this later. I am pretty sure the rich guys are rich because of aspects of their sitch that are not well described by “factors of production.”

Liberals losing the plot

Your take is not the”tolerant” one

In my view, there is some excellent work being done on the near left to resist the collapse of the Republic. Actual centrists (as opposed to self-regarding, fake-balance centrists) have also been doing some admirably patriotic stuff.  Obviously, I will not try to list the accomplishments. There are at least 150 million sane politically-helpful people in the USA.

But a lot of liberals just can’t resist the urge first to prove how clever they are, which can occasionally force them to lose the plot.  Here I will give a couple examples in order hopefully to nudge the wrong-doers into more patriotic behavior.

I have noticed recently some public intellectuals on the left enjoying a spirited debate about who is and who is not a “neoliberal” and whether the term itself connotes a progressive view of politics.  I think they should redirect their focus to what is actually going on in the world and apply their sharp minds to convincing people to act in ways that would improve things.

For example, instead of asking if support for the ACA is “neo-liberal”, they could write some essays patiently explaining why its going away would hurt actual people.  I know those essays seem already to have been written, but there is nothing wrong with repetition – or a successful effort at distillation and clarification.   Besides, the bar set by a semantics debate is easily cleared.  Pretty much any effort would be more helpful.

This second one is going to seem more controversial.  It challenges, rather than flatters, cherished hopes and is not calculated mostly to win your approval.  The generalization that all Republicans are evil is silly and easily falsified.  We all greatly admire the heroes in Portland.  But let’s leave discussions of who is this or that to the right. Righties just love giving themselves stay-out-of-jail-free cards by opining on how the latest bad actor is fundamentally a “good person” whose actions do not reflect his essential character. WTF?

As the sane conservative, David Frum, has mentioned on Twitter, “you are what you do.”  Perhaps he shares my view that Forrest Gump was the second greatest epistemologist in history, behind the pragmatists who are all tied for first.  (Aside: liberals please resist temptation to debate about whether the guy following several tied for first is actually second.)

Who you are is a meaningless abstraction. And in politics what matters most are the effects of your actions.  People who are still down with the Republican tribe and plan to vote Republican in the next mid-term election seem to me to be enabling Trump.  It does not matter if they are good people, although there is apparently a ready market for suggestions that they must be. What matters is the effect of their behavior. Leave the rest to St. Peter.

Maybe the too-clever liberals believe that conservatives remaining loyal to the Republican party are not really enabling Trump or that doing so would be no big deal anyway.  FWIW, I would be happy to be challenged on my take on that.  It might pull me out of my own great depression.

What is weird, though, is seeing liberals who share my take on the practical issue getting distracted by who these folks actually are.  Nor is the too-clever liberal take really the tolerant and nonjudgmental one. It blithely passes judgment on who is and, by implication, who is not a “good person.”  It would be more helpful to focus on the effects of actions and resist the normative impulse until assessing the effects themselves.

Don’t say, Tom and Dick are good, even though they are supporting Trump. Point out that they are enabling Trump, leave aside what that says about them, and focus on whether the effects of their enabling are good or bad.  True, at some point, you do need to go full normative. No avoiding that. But delay that satisfaction just one step, in the interest of America and the world.

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Judge what he does, not who or what “he is”

Remedial remittance arithmetic

As a follow-up to my rant earlier today, I thought I would write down what determines Fed profitability and thus remittances to the Treasury.  Maybe, I could try the tougher task of being correct, rather than just critical.  I have been whining a lot lately, you twelve may have noticed.

Bloomberg spreading nonsense still ticks me off, but it ain’t about Bloomberg, in fairness. I have developed an allergy to journalists getting simple stuff wrong in the past year. But it matters more in politics, than in finance.  So I should be clear that I pick on Bloomberg only because they cover stuff I would claim to understand and where normative issues are most easily bracketed.

Here I am just going to ignore two things that deliver a bit of slippage between Fed profitability and remittances. First, remittances need not be timed to the achievement of profits, which seems neither feature nor flaw, to me. Second, some might say that not all profits earned at the Fed are returned to Treasury, because the Fed pays “dividends” to private banks for their capital. I view that as a fixed cost.  In any case, it is small beer by the standards of the trend in Fed profits and the variation around it. So I ignore it, along with timing issues.

When the Fed has a normal balance sheet comprising only bills on the asset side and no interest-bearing reserves on the liability side, the source of Fed profitability is simply the gap between market interest rates and the zero cost of finance the Fed pays on currency (and much less importantly) reserves. Traditionally, this is called seniorage on “the” monetary base. But I am going to call it pure seniorage, to distinguish it from another source of profitability that has arisen recently, when the Fed has had a balance sheet that has been abnormal, at least by historical standards.  Importantly, the interest elasticity of demand for base money is low enough, i.e. close enough to zero, that pure seniorage correlates positively with rates, at least with rates in their plausible range and at horizons long enough to be relevant for budget analysis. People get that backwards.

We may describe the Fed’s balance sheet as “abnormal”, at least by convention, when the size of the asset side exceeds that required to meet currency and non-interest-bearing reserves demanded at the target fed funds rate.  Recently, the abnormal balance sheet has involved a large stock of interest bearing reserves (and other interest bearing liabilities, which we will set aside for simplicity) on the liability side and longer-maturity government-like debt on the asset side.  We call that QE.

In this environment, there is – or more strictly, may be — a second source of profitability, that arising from positive carry.  Lets’ call that trading profitability, because it involves a speculation on the path of short-term interest rates, which – in fairness – the Fed may be uniquely qualified to engage in.  (Hence the rates signal aspect of QE.)  And let’s be careful to distinguish it from what I am calling pure seniorage.

I think people, such as for example Stephen Stanley, sometimes overlook that the source of trading profitability is not the low-level of the fed funds rate or thus the low rate paid on excess reserves. And nor is it the positive slope of the yield curve.  To see this easily, just imagine a counterfactual (or recent experience) in which the slope of the curve less than fully compensates for a possible rise of short-term interest rates.  In such an environment, carry trades held to maturity of the asset leg would generate losses.

I guess how you analyze trading profitability is a matter of (modeling) taste.  But these three sources sum, by construction, to all of it. We can think of trading profitability as reflecting three things:

  • Luck
  • The Fed’s forecasting edge
  • The term premium in the yield curve

The first factor cannot be relied upon going forward. At some level this is painfully obvious. But I think some of those claiming that a lower balance sheet just necessarily means less profits / remittances may be forgetting this and just extrapolating the history of the past decade, during which carry trades – of the sort QE represents or, hell, is – have been very profitable.

The second factor is perhaps a bit more reliable, at least at short horizons, on the grounds that the Fed has a better insight into the path of the funds rate over the very near term than the market does.  But, the Fed demonstrably does not have a better view than the market at even medium term horizons, as the history of the past decade has shown clearly.

And whatever the Fed’s medium term advantage might have been, the escape from zero bound will predictably make it less compelling. In the interest of time and not losing the plot, I will leave figuring out why that is the case as an exercise for the reader.

So that leaves us with the third item.  The term premium is a very important determinant of the prospective profitability of carry traders, particularly among those – like myself – who still have some modicum of respect for the idea that the fixed income market might often be roughly efficient.

One problem is that term premium is not directly observable and there are good grounds for skepticism about attempts to estimate it.  Right now, the term premium does not seem to be very large, I would point out with appropriate humility.

But the point is that the Fed cannot control the term premium, even with QE, I would say. And for those who say that the Fed can control the term premium with QE, then even spotting that premise does not get you very far in this context. After all, asset rundown would raise the term premium, and thus lift the prospective profitability of the remaining carry trade, arising out of the remaining QE assets. For example, if cutting QE assets in half raises the term premium from 0 to 50 bps, that is a win for total remittances over time.

I have said it before and I will say it again. QE will have been conceived, implemented, scaled up, tapered and run off before the consensus even has the remotest clue of what QE is or how it affects things.  Getting its effect on Fed remittances wrong in just par for the course.  For me, that is a recurring theme.

Yeah, that’s the main point. Whatever your take, even if you insist on holding to the wrong one, all this remittance stuff is peanuts relative to the broader trends in the budget and egregious lying about them.  It is interesting much more as an example of how QE is intellectual kryptonite, turning even sensible people’s brains to mush.