The monetary base is one of the best indicators of an accommodative or restrictive monetary policy. This article discusses the U.S. monetary base trend and its impact on real economic activity.
Before I discuss the monetary base trend, it is important to note that the central bank determines the monetary base (total reserves plus currency). However, it is the commercial banks that decide the extent to which an increase in the monetary base changes the quantity of bank loans and the broader monetary aggregates (M2 or M3). In other words, a central bank's push for an expansionary monetary policy can be offset by a conservative approach taken by commercial banks. A clear conclusion is that a central bank's zero interest rate policy to spur lending and hence economic growth becomes futile if commercial banks adopt a conservative approach to prevent losses.
I started with this explanation because the current scenario in the U.S. is exactly the same. The policymakers are trying to adopt an aggressive policy to spur lending and growth. Commercial banks, on the other hand, are tightening lending standards resulting in poor credit growth. As such, artificially low interest rate (negative, when adjusted for inflation) serves two purposes - First, it is an extended bailout for banks with a battered balance sheet after the financial crisis. Second, it encourages speculation in different asset classes.
The chart below gives the adjusted monetary base in the U.S. Very clearly, the policymakers have adopted a highly accommodative policy after the crisis and the monetary base has gone through the roof.
If this policy were to work, credit growth would have surged resulting in relatively robust economic activity. Credit growth however has been dismal after the financial crisis (especially for the household sector). Even for the corporate sector, there was a period of deleveraging before credit growth is starting to pick up gradually. Overall, artificially low interest rates have done little to boost economic growth. The evidence of this comes from the money turnover in the economy. As the chart below shows, the M2V is at multi-decade lows indicating very weak real economic activity.
So where is all the money?
The excess reserve of depository institutions was at $1.6 trillion according to the latest data. As the chart below shows, the excess reserves have surged with a surge in the monetary base.
In other words, banks find it more attractive to deposit the excess reserves with the Fed and earn a 25bps interest on the reserves than to lend the money to consumers or corporations. Even if banks are lending, the standards have been tightened and it offsets loose monetary policies of the central bank. At the same time, one can conclude that the supply of money is in excess compared with the demand. It therefore makes no sense to keep interest rates at near-zero level. In the current scenario, it is doing more bad than good. Low interest rates are punishing savers and also encouraging speculation in different asset classes. A typical household needs to beat inflation in order to preserve the purchasing power of their money.
Can things change if the Fed reduces the interest paid on reserves from 25bps to 0bps?
Evidence from the ECB does not suggest that reducing the interest paid on reserves would spur lending. The chart below gives the change in M3 after the ECB reduced interest on excess reserves to zero. Very clearly, there is no meaningful change in M3. Again, the important point is the willingness of overleveraged consumers to borrow and the willingness of banks to lend in the fragile economic scenario.
Coming back to the impact of current monetary policies on the real economy, I have two other charts, which highlight the point that economic recovery is very sluggish. More importantly, they highlight the point that easy money policies have not always worked. It would have made more sense to slash interest rates and expect a surge in credit growth if households and the corporate sector were not highly leveraged.
The first chart gives the total change in U.S. employment comparing 11 post-war (WW2) recessions (60 months after the peak).
The second chart gives the total change in U.S. output comparing 11 post-war recessions (20 quarters after the peak).
I agree that the current recession has been the worst and recovery might be slow. However, I am sure that easy monetary policies are not the answer to the current problem. The problem of excessive debt can't be solved by more debt. The diminishing impact of debt on GDP growth is clearly visible in the last few years. The U.S. government debt has already surged over 100% of GDP with the expected deficits of $10 trillion over the next 10 years. The solution to all these problems is simply not zero interest rates. Contrary to benefits, the zero-interest rate policy has resulted in excessive speculation across asset classes.
I am not denying that ultra expansionary monetary policies do support the economy to some extent. The key point is that if free markets are not allowed to function, a recession might take the form of depression eventually. As the chart below shows, the time spent in recession had declined significantly (primarily due to government intervention) prior to the current recession. The previous excesses, which built on over a period of time, resulted in the deep recession of 2008-09.
In conclusion, policymakers really do need to think beyond expansionary monetary policies if the current problem has to be solved. The current policy is more targeted towards delaying the inevitable than solving the excessive debt problem.
From an investment perspective, the current financial and economic scenario demands diversification across asset classes. Investors can consider exposure to the following ETFs and stocks -
SPDR S&P 500 ETF (SPY) - It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. Also, with excess money flowing into risky asset classes, the S&P should trend higher over the next 3-5 years. Therefore, the expected correction can be used to consider fresh exposure to the ETF. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.
Besides physical gold, gold ETFs are a good option for long term and investors can consider exposure to the SPDR Gold Shares (GLD) ETF. The investment seeks to replicate the performance, net of expenses, of the price of gold bullion.
iShares Silver Trust ETF (SLV) - The Trust holds silver bullion and is designed to provide investors with a simple method to gain exposure to the price of silver. The ETF has a relatively low expense ratio of 0.5%. I am recommending silver as it has significant upside potential in the long term and I discussed the prospects for silver in one of my earlier articles.
iShares MSCI Emerging Markets ETF (EEM) - The iShares ETF corresponds generally to the price and yield performance, before fees and expenses, of publicly traded securities in emerging markets, as represented by the MSCI Emerging Markets Index. It is important to diversity the portfolio to emerging markets as the EM's have the potential to significantly outperform developed markets in the long term.
Vanguard Energy ETF (VDE) - The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the energy sector. With a low expense ratio of 0.19%, the ETF is a good investment option in a sector, which has good upside potential in the long term considering incremental demand from Asia and continued expansionary monetary policies.