I believe credit data is of significant importance when evaluating economic trends and monetary policy. As shown in the charts below, credit growth is correlated with economic growth (SPY, QQQ) and inflation, because loans boost spending and the money supply. As long as the rate of credit growth outpaces the rate of debt repayment, net new credit remains positive, and this is sustainable. When debt repayment is greater than new credit, the economy experiences deflationary pressures.
I'm fairly sure credit growth is going to weather rising rates well and maintain a positive position, pushing inflation and GDP higher. There are huge amounts of reserves in the banking system for the loan supply side of the equation. The demand side points to improving fundamentals as well. Household debt-service-payment-to-income ratio is at 30-year lows. Balance sheets have been repaired, with net worth at an all-time high. This scenario bodes well for continued credit expansion. The U.S. economy and credit growth has momentum and has reached escape velocity.
I don't believe in the idea of secular stagnation, or that our economic scenario will prove to be the same as Japan's. The chart below shows total private sector credit in the United States and in Japan. The financial crisis and recovery in the U.S. occurred when credit decreased and then subsequently recovered. In Japan, starting around 1990, Japan's credit growth stagnated, coinciding with deflationary pressures. The upward move in credit in the U.S. compared to Japan does not signal over-leveraging, because debt service payments as a percent of income are historically low, and household debt to GDP has fallen in the U.S. as well.
Not only are fundamentals pointing to future credit growth, we're already near record high credit as shown by private sector credit and consumer credit data. Total credit in the economy is at an all-time high, while the growth of credit is approaching 2007 levels. All this while the Fed Funds rate is being held near zero. I would say it's a pretty good idea to move interest rates up here.
Bears will say it's 1937 all over again. This is when the Fed doubled reserve requirements to keep reserves in the banking system. I see the parallels, but I don't think this is the same. There is a difference between gradually raising rates and doubling reserve requirements. Also in 1937, unemployment was at 14% when the Fed tightened. Credit growth was not as strong, and credit had not yet recovered to peak 1929 levels, such as the situation we have today, except with 1929 being 2007.
Raising rates — really only increasing the interest paid on excess reserves, setting a floor under interbank rates — is rather benign. I would expect credit growth to continue here given credit fundamentals for future supply and demand. There is a lot of loan growth potential in the system, and demand fundamentals are strong. These are shown by the debt-to-income ratio being low, household debt to GDP declining, and net worth being at an all-time high.
I think there are inflationary risks in QE, as shown by excess reserves in the banking system and repaired loan demand fundamentals. It's more likely the U.S. is going into inflation than deflation in the long term. In the near term, I believe in steady economic improvement, rising rates, and an appreciating U.S. dollar. The Fed probably shouldn't be holding rates near zero, based on current and potential credit growth and its correlation to GDP growth and inflation.
Disclosure: I am/we are long DUST.
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