OnTrack Reading

This section deals with several aspects of monetary theory, as I have come to understand it.

First, I will discuss a paper I wrote in 2001 explaining how I came to believe in a very strong form of monetary theory and laying out the implications of that theory.

Evidence gathered in the late 1970’s convinced me that the Federal Reserve has the power to almost immediately change the direction of the economy, but that it takes almost exactly six months for such a change in direction to be evident. Once such a policy shift is underway, stock prices will react within a month or so, whereas any effect on overall prices (the CPI, for example) will take as long as three years to play out.

Download the paper: A Monograph on Monetary Policy

Topic 1: Comments on the Monograph

Assuming you have downloaded the paper, following are some comments on its contents:

Page 1: Here I caution you that to accurately assess the data that led me to conclusions expressed in the monograph, you will probably need access to original data. Seasonal adjustments over the years have almost certainly erased most of the bulges in weekly money supply data that were originally reported.

Pages 1 and 2: This is a statement of a strong form of monetary theory. By that I mean the Federal Reserve is the main actor in the script. They have tremendous power over the near term to influence economic activity if this theory is correct.

I also specify the mechanism by which they exert that power, that is, by their management of excess reserves, and that the influence of excess reserves is exerted first on the money supply, then on stock prices, then on the level of economic activity and finally on the overall level of prices generally.

Page 2: The Hot-Potato Theory of Monetary Growth describes the mechanism by which I believe the Federal Reserve ends up affecting the money supply. Note that nowhere do I assume that the Fed is aware of this particular mechanism, and, in fact, the evidence available would indicate that they are not aware of it. Based on the evidence of the late 1970’s, however, I am nearly certain that the hot-potato theory describes reality quite well. The name I’ve given this theory is probably too cute, but hot-potato does convey my sense of the mechanism involved.

Page 3 (bottom) and 4: In the 1970’s, the Monetary Base was considered a key leading indicator of the money supply, and the M-1 money supply was considered a leading indicator of both the economy and price levels. This part of the monograph describes my “Eureka” moment, when one night it dawned on me that Currency in Circulation (a significant portion of the Monetary Base even then, though it is a much larger portion now) actually had to be a lagging indicator of nearly everything because changes in currency quite logically follow price changes. So, I subtracted Currency in Circulation from the Monetary Base to arrive at a number I called Effective Reserves. On further examination, it became startlingly clear from the data that Effective Reserves were, at least then, an exceptionally reliable leading indicator.

Even today, if you graph the currently reported Effective Reserves for the 1950 to 1980 time period against economic numbers like Retail Sales, Industrial Production and Gross Domestic Product (GDP), you might get a strong hint of the forecasting power of Effective Reserves on economic activity. Since that time, however, things have gotten messy. But that does not mean that the Federal Reserve has somehow relinquished its powers. It only means that it has become harder to determine those powers by examining the data.

Page 5: Here I explain the reason it became impossible to use Effective Reserves as a forecasting tool after the introduction of NOW accounts around 1980. In addition, Demand Deposits became useless for years because they fell rapidly as people shifted balances to the dual-purpose NOW accounts, which served as both a savings account and a demand account simultaneously. Years have since passed and it now appears that some forecasting value has returned to Demand Account balances, but not to the degree it existed in the 1950 to 1980 era.

Page 6: The conundrum I discuss here is the most important policy point of the monograph. Is it possible for the Federal Reserve to actually be tightening policy inadvertently (at least one would hope it’s inadvertent) when they appear to be easing aggressively? I believe it is and carefully explain why this is so in the monograph. In a nutshell, while everyone (including the Fed, presumably) is watching the fed funds rate, the people running the day-to-day mechanics of the reserve desk can be, quite by accident and unaware of the implications, withholding reserves on key days. Again, one would hope at least that this would be by accident, though if the Fed is aware of this theory, and if it works as I claim, they could easily be taking more away with the hidden hand than they are giving with the one everyone is watching. Restating my point, I am reasonably sure that I could run the daily fed funds reserve position in a manner that would have everyone believing that policy is easing, while I was actually tightening reserve positions.

Page 7: I believe the old regimen was preferable to the present one, so here I point out the characteristics of the old regimen in case policymakers decide to return to that time. (Essentially, Demand Deposit balances earned no interest and the Reserves required to be held against Demand Deposits balances were higher.) I believe they should establish the old order and then seek to put the money supply on autopilot by stabilizing total reserves, while letting both short and long term interest rates determine their own level.

Pages 8 and 9: At the time I wrote the monograph, the Federal Reserve was becoming concerned about the problems that would occur if the fed funds rate had to be taken too close to zero before the economy started to rebound. My concern, as expressed in the monograph, is that they would fall into the trap that I believe Japan had been in for several years, not realizing that they had a way out of the trap because it was counterintuitive. That is, to ease, they must first restore a penalty for holding excess reserves and the most efficient way (though not the only way) was to raise the fed funds rate, rather than lower it. As I state in the monograph, if you grasp this essential point, you then understand the problem as I see it.

This concludes the overview of the monograph. The rest of this page on Monetary Policy discusses evidence that the theory is accurate, along with some of the implications.

Topic 2: Are Demand Deposits Again a Useful Leading Indicator?

Editorial Note: I apologize for the length of this page, but this is a website primarily devoted to dealing with struggling readers, and so I’m going to squeeze all the monetary issues onto this one page.

I believe there is again value in examining weekly demand deposit numbers, but with caution. Remember that demand accounts have been declining in importance for years because most individuals have switched to NOW accounts, even though those accounts now pay such a pittance that they are hardly worth the time it takes to open them. But this is exactly the sort of problem one faces when attempting to use demand deposits as a leading indicator. Another is that businesses hold most demand balances now, and so if a bank develops a way to allow its business customers to earn some interest on their unused balances, there can be a rapid shift in the level of demand deposits as that innovation spreads through the banking system.

Still, if the Federal Reserve is up to something, it’s likely to be expressed in Demand Deposit balances. The problem is that there will be a lot of noise, and they will probably predict ten of the next three recessions. Having said that, here is the historical record of monthly demand deposits and here is a graphing package from the St. Louis Fed that is quite useful once you learn how to adjust the parameters.

Here are some hints on using the graphing package:

1. Put DEMDEPSL (demand deposits seasonally adjusted) in as the series id for Series 1 and Refresh the graph by clicking on Large or X-Large.

2. A box for a second series will open with the link “find a series” next to it. Use the link to find any economic series you want and click it. Just make sure it’s a seasonally adjusted series.

3. This will result in a confusing graph because both series are being graphed on the left axis, so change the axis of the second series to “right” and also adjust the dates so that both series are being graphed for the same time period.

The result will be a graph which you can examine for lead/lag relationships quite easily, especially if you limit the graph to a period of 10 years or less. Five years is even better for counting the months on the graph.

At this point, I was tempted to try to produce evidence that Demand Deposits do lead economic activity, but remember that I also said that during the 1950-1980 era, although Demand Deposits were a leading indicator of economic variables like Real GDP, Retail Sales, Durable Goods Orders and Industrial Production, an even better leading indicator was the Effective Reserves number. Plus, since 1980, Demand Deposits have been severely affected by changes in both banking regulations and banking practices. Thus, although I do feel that one can obtain some forecasting value from the Demand Deposit number reported each week, I also have found that there is so much statistical noise in the number that I cannot recommend that others use it for forecasting.

So, with that caveat in mind, play with the graphing package described above and see if you can ferret out a leading role for demand deposits. E-mail me if you find something particularly interesting that you’d like to discuss.

Again, bearing in mind that Demand Deposits are a suspect forecasting tool now, here are my thoughts on the recent monetary policy moves: At the time of this writing (February 2008) the Federal Reserve has apparently been easing aggressively in an attempt to prevent the US economy from sliding into a recession. Yet, if you examine the Demand Deposit data you will find that they have been falling quite sharply over the past several months. This, in my opinion, does not bode well for those assuming that the Fed is going to accomplish its presumed task, and in fact it would appear that they are instead well on the way to ensuring that we will enter a recession. My personal opinion is that we have already entered it in the 4th quarter of 2007 and will not exit until at least the 3rd quarter of this year because it is already February and it will take six months for economic growth to become apparent if the Fed manages to reverse the current relatively severe drop in Demand Deposits.

Topic 3: A Seasonal Fed Policy

Many stock market participants long ago picked up on a peculiar tendency for the U.S. stock market to outperform its long-term average return during the months from October to April and under perform during the months from April to October. In fact, when I first examined the numbers several years ago there was not a ten-year period of time going back over fifty years where October-to-April did not outperform April-to-October and in some of those ten year periods, all of the returns were generated in the October-to-April portion of the years and none in the April-to-October portions.

Recall that the strong form of the Monetary Theory posited in A Monograph on Monetary Policy states that an injection of reserves into the system is reflected very quickly in the economy, beginning with the financial markets, and in particular, the stock market.

All that is then required is the assumption that money grows strongly in the last few months of the year and slows sharply going into April. And, in fact, that is exactly what it does, but on a non-seasonally adjusted basis only. After seasonal adjustment, no particular pattern emerges. Now, think about that. Money does grow rapidly going into the holidays, and it does shrink rapidly following the holidays. This is factual.

So what? We seasonally adjust it to get a true picture, right? Well who’s to say that it’s a true picture? All the seasonal adjustments do is smooth data. If, for fifty years or better, the Fed has been supplying too much money for the holidays, then the seasonal adjustments would have long ago adjusted the too much down to just right. Similarly, if economic activity has accelerated, though with a lag of several months, during a corresponding six month period, and decelerated in the following six months, year after year, the seasonal adjustments for each of the economic series would adjust those patterns away. In fact, everything is seasonally adjusted–except the stock market.

And this process, once begun by the Fed, would be self-perpetuating because to reverse it would generate a strong drop in the seasonally adjusted money numbers which the Fed would seek to avoid. And so, each fall the Federal Reserve begins adding reserves to cover the increase in money supply it believes will be necessary to accommodate the seasonal increase in holiday spending. For years it has overestimated the need for those funds. Yet each year the seasonal adjustment factors conceal the excesses, leaving only the consistent increase in stock prices to mark the error in policy.

If true, what are the implications? Well, first, the Federal Reserve should begin gradually to reduce the reserves supplied for the perceived holiday needs until the market anomaly quits appearing with reasonable regularity. And second, when the market actually falls during the October to April period, as it was doing the at the time this was written (February of 2008), it is appropriate to ask whether sharp easing of policy supposedly underway at the time was, in reality, not an easing at all, but rather an example of how the Fed can appear to be easing while inadvertently tightening policy instead.

Topic 4: The Limits of Monetary Policy

While the monetary theory espoused on this page, and in the monograph, ascribes tremendous economic and pricing power to the Federal Reserve, one should not make the mistake of assuming that other factors are insignificant. In fact, the effect of monetary policy on aggregate economic activity is relatively small, even though monetary authorities have it within their powers to easily create the next recession. Over the long term, however, other policies easily overwhelm monetary policy in creating, or frustrating, economic growth. Tax laws, NAFTA, various industry regulations, etc., have a cumulative effect that determines whether or not the U.S. economy takes twenty years to double in size, or forty.

The exception to this is when, as in the 1930’s, the managers of the Federal Reserve so constrain the growth of the money supply that they frustrate economic growth for an extended period of time. In my opinion, this happens because labor is generally unwilling to cut its price in a deflationary environment. The result is that industry demands less labor, and the recession becomes a full-fledged depression.

However, while the Federal Reserve is not usually the dominant factor determining long-term economic growth, it is the one agency of the government responsible for the overall price level. Proper management of reserves would maintain a stable price level for decades, but it is also within the Fed’s power to double the price level, or quadruple it, and over a relatively short period of time, such as a decade. Furthermore, once prices start moving up with regularity, it would be a trivial matter for the Fed to accelerate the rate of increase dramatically, just by supplying additional reserves to the banking system.

Topic 5: The Japanese Experience

I apologize in advance, because this is going to sound pretty absurd to anyone reading this next section, no matter how I put it. I will try to adhere strictly to facts, however, and not speculate.

Note the paragraph in the Conclusion of the monograph on page 9 that reads: “Whether such a system will ever be structured is questionable, but an immediate application of the theory to Japan’s current situation might be of help both to Japan, and to our future decision-making processes in this arena.”

I tried to interest one or two researchers at the Federal Reserve in my monograph. One actually read it in fact. His response was that he had his own research to attend to, which was reasonable.

So, more or less as an afterthought, I emailed a copy to the Bank of Japan. Here are two paragraphs from that email:

“I am unable to convince anyone in the Federal Reserve System in the United States to consider the contents of the attached Monograph on Monetary Policy which I drafted nearly two years ago. However, since the contents are directly relevant to Japan’s monetary policy as well, I thought you might be interested in reading it.

“Should you decide that what I’ve written has merit, and decide to attempt to implement its conclusions, perhaps we in the United States can learn from your experience before we undergo our own decade of stagnation.”

That was the end of it. I never heard a word from them and only recently (in February of 2008) dug the old email out of the computer. I sent it on the evening of Wednesday, May 21, 2003.

After I retrieved it, out of curiosity, I checked out the Japanese stock market’s action around that time and here is what I found.

That extreme low point at 7607 on the graph occurred on April 28, 2003. Here are the day-by-day numbers. Note that after that extreme low, the Nikkei 225 traded between 8,000 and 8,250 through May 28th. Then look what happened after that.

Coincidence? Or did someone actually decide to test the theory? I have no idea, but I said I’d stick to facts, and the fact is that an 80 percent decline in the Nikkei 225 that lasted a full thirteen years and five months came to an end just seven days after I sent that email. (I do believe that stock markets react almost immediately to an injection of reserves, incidentally.) Or, did it end nearly a month before, on April 28th and was all this just a huge coincidence? My money is actually on coincidence, but it’s fun to ponder the other possibility.

How about the Japanese economy? Here is a quarter-by-quarter table of Japan’s GDP performance. Note the acceleration in the 4th quarter of 2003 and the 1st quarter of 2004. Regardless whether Japan’s central bank was conducting an experiment based on the contents of an overseas email, this is almost exactly the pattern you should expect to see if reserves were provided beginning in the middle of the 2nd quarter. The 3rd quarter would remain weak and late in the 4th quarter, economic growth would become evident.

As for consumer prices, I believe they continued to fall until late in 2004, then began to rise slightly for a time. Again, price increases follow a reserve increase only with a very long lag, on the order of one or two years, so this is the behavior you would expect to see.

Did Japan’s central bank somehow find a way to pump reserves into the system and actually get their bankers to usefully circulate them? Probably, because their stock market, their economy and their price level all behaved as though they did. But did they do it in response to my email? That’s hardly likely, but if they did manage to get reserves circulating in a zero-percent fed funds environment, it would be interesting to know how they did so.