Forget The Sept. ’15 Fed Tightening – There Has Been A Stealth Tightening Since Sept. ’14

by Paul Kasriel, The Econtrarian

The late, great Milton Friedman used to preach that you don’t assess the degree of monetary policy restriction or accommodation by the level and movement of interest rates but rather by the behavior of monetary quantities.

For Friedman, the monetary quantity by which he judged the stance of monetary policy was some definition of the money supply – currency and some of the deposit liabilities of the banking system. Meaning no disrespect to the greatest monetary theorist of the 20th century, but the monetary quantity I prefer to use to measure the stance of monetary policy is on the asset side of the banking system’s balance sheet — the sum of banks’ cash reserves provided by the central bank and the loans and securities granted by the banking system. By my measure, the Fed has been gradually tightening its monetary policy at least since September 2014. Moreover, in recent months, Fed monetary policy has become downright restrictive. This is illustrated in Chart 1. Plotted in Chart 1 is the behavior of the sum of commercial bank credit – loans and securities held by U.S. commercial banks — and the cash assets held by these commercial banks – largely banks’ cash reserves created by the Fed. Past readers of my commentaries will recognize this monetary quantity as my concept (really Austrian economists’ concept) of “thin-air credit”. I refer to it as thin-air credit because cash reserves provided by the Fed are created, figuratively, out of thin air and so, too, is commercial bank credit in the fractional-reserve banking system that we have in the U.S. The red bars in Chart 1 represent the month vs. year-ago month percent changes in this monetary quantity. The blue line represents the three-month annualized percent changes in this monetary quantity. To put things in an historical context, the median percent change in the annual averages of this monetary quantity from 1975 through 2015 was 6.62%.

Chart 1

The year-over-year percent change in the sum of commercial bank credit and cash assets peaked in July 2014 at 9.74% (the red bar just to the left of the solid black vertical line in Chart 1). The Fed’s third round of quantitative easing (QE), which had begun in September 2012 and was terminated in October 2014, was still being phased down in July 2014. The year-over-year percent change in this measure of thin-air credit has trended lower since July 2014, slowing to only 4.45% as of July 2015. The more variable three-month annualized growth in this measure of thin-air credit also has been trending lower since July 2014, slowing to 1.25% as of July 2015. Against the backdrop of a 40-year median growth rate of 6.62% for this measure of thin-air credit, recent months’ growth rates in it are relatively low,implying that the Fed’s monetary policy has gone from accommodative in July 2014 to restrictive in July 2015. Plotted in Chart 2 are the year-over-year percent changes in the two components of this measure of thin-air credit – the cash assets held by commercial banks, primarily cash reserves provided by the Fed, and loans and securities held by commercial banks. This chart shows that key driver of the slowdown in thin-air credit growth since July 2014 has been the slowing in cash assets held by commercial banks, i.e., a slowdown in the Fed’s provision of bank reserves. In each of the three months ended July 2015, commercial bank cash assets have contracted vs. year ago. Although commercial bank credit growth has slowed in recent months, it nevertheless remained relatively robust in July 2015 at nearly 7% on a year-over-year basis.