Why Is The Fed Always Last To Know?

Summary

• The Federal Reserve is tightening monetary policy when growth is slowing, a policy mistake.
• Money supply growth shows the Fed is tightening too quickly.
• Federal Reserve asset sales are impacting the economy.

Federal Reserve Asset Sales & Money Supply Growth (M2)

Back in December 2017 I wrote an article titled "The Math Behind Quantitative Tightening - Why It Will End Early." In this article, I outlined why the pace of Federal Reserve tightening was too aggressive and why it would lead to a choppy equity market in 2018. Here's an excerpt from that post which you can find here:

The Federal Reserve has laid out a pace of reducing the balance sheet or contracting the monetary base by $10 billion per month and increasing to $50 billion per month by the end of 2018. Given their pace, the average reduction is roughly $30 billion per month.

Given the money multipler of 3.55, a $30 billion dollar reduction in the monetary base will reduce the money supply by just over $100 billion per month, assuming the money multipler holds constant.

The money supply is currently increasing at a pace of roughly $50 billion per month. This rate of monetary tightening is going to cause a rapid decline in the money supply.

Money Supply:

Source: Federal Reserve

The growth rate in the money supply is already contracting due to rapid contractions in bank loan growth.

Money Supply Growth:

Source: Federal Reserve

The growth rate in the money supply (M2) has been under severe pressure since the Federal Reserve has started tightening monetary policy.

If the Federal Reserve continues to tighten monetary policy at the pace that they have laid out, the money supply growth will contract to nearly 0% by the end of 2018.

Money Supply Growth With Estimated Federal Reserve Tightening:

Source: Federal Reserve

Given that M2 Growth + Money Velocity Growth= Nominal GDP Growth, shrinking M2 will cause nominal GDP growth to fall.

M2 Growth + Velocity Growth = Nominal GDP Growth:

Source: BEA, Federal Reserve

I followed that post up with an article at the end of January titled "Quantitative Tightening Is Right On Schedule." In that post, I updated the growth rates of money supply growth and reiterated that the pace of tightening was too fast. Here's an excerpt from that post which you can find by clicking here:

Assuming the money multiplier holds flat, the rate of M2 growth can be estimated using a multiplier of 3.55.

Estimated Path of M2:

Source: Federal Reserve, EPB Macro Research

With these numbers, the year-over-year rate of M2 growth can be calculated to obtain half the GDP equation in Fisher's equation of exchange (M2 Growth + Velocity Growth = GDP Growth).

Year over Year Growth in M2:

Source: Federal Reserve, EPB Macro Research

The chart shows that by the end of 2018, the rate of M2 growth is nearly negative. The rate of M2 growth has already been decelerating sharply since the end of 2015 when the Federal Reserve started raising rates, noted by the black line in the chart above. These assumptions show the rate of money supply growth to simply continue lower. A continuation puts M2 growth near zero by the end of 2018. It is for these reasons that GDP growth, while up several quarters in a row, will not be able to rise to a high nominal rate. This additional monetary tightening in the form of asset sales is going to severely impact nominal GDP growth unless there is an offset in velocity. Velocity growth year over year has been negative for 27 consecutive quarters.

Velocity Growth Year over Year:

Source: Federal Reserve, EPB Macro Research

Velocity has been increasing, still negative, yet increasing over the past few quarters. Perhaps this trend continues but to assume a high growth rate in velocity is premature in my opinion. The factors that are responsible for weak velocity, including high levels of debt, low levels of productivity growth, and worsening demographic trends are still present if not getting worse.

The offset in velocity will not be enough to counter the downward drag in GDP caused by the slowdown in M2 growth. It is more likely the increase in velocity is part of a normal bounce off easy comparisons similar to 2014-2015 and 2009-2010. The growth of Nominal GDP in 2018 should be lower than the growth in 2017.

Year-Over-Year GDP Growth:

Source: BEA, EPB Macro Research

Currently, as the Federal Reserve continues to unwind the balance sheet, money supply growth is contracting rapidly. The declines in M2 growth will cause slower growth in Q1. Given the current data, GDP for Q1 could fall below 2% on a Q/Q annualized basis. Growth with a 1 handle is a far different conversation than 3% growth.

Federal Reserve Balance Sheet:

Source: Federal Reserve, EPB Macro Research

M2 growth has fallen down to 4.0%. Given that year over year GDP growth is equal to M2 growth + Velocity growth, the contraction in M2 growth by default gives you a weaker starting point for nominal GDP.

M2 Year-Over-Year Growth:

Source: Federal Reserve, EPB Macro Research

Money supply growth (M2) continues to plunge at an even faster pace than in my previous forecasts above.

The stock market is beginning to price in the reality of slower growth. Interest rates have seemingly bottomed with (TLT) reaching a low on February 21. There are even some market pundits and forecasters who have started to notice growth slowing data. To be fair, there were really not any strong data points (aside from ISM and PMI survey data which I don't find as useful as hard economic data) for the January reporting period.

The market knows growth is slowing and Wall Street is starting to catch on too.

Bloomberg reported growth is slowing with proof in this interview: "Ecri's Achuthan Says Tariffs May Be More Bark Than Bite."

Source: Bloomberg | Click Here For Entire Video

The only one who has shown no signs of acknowledging the growth slowing data is the Federal Reserve. All the members of the Federal Reserve seemingly want to increase the pace of monetary tightening without addressing the collapsing rate of money supply growth.

Most recessions begin because the Federal Reserve is too aggressive with monetary policy at the end of a business cycle, causing an inversion of the yield curve and a credit crunch.

It seems this time is no different. I continue to forecast that the Federal Reserve will realize this toward the second half of 2018 and slow down the pace of monetary tightening. The market (SPY) will see this prior to the Federal Reserve. With the yield curve dangerously close to an inversion, one more policy mistake can start the countdown clock to the next recession.

30-5 Spread:

Source: YCharts, EPB Macro Research

Analyst’s Disclosure: I am/we are long TLT, IEF, SHV, GLD, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Short JNK, XLV, EWI

Comments

[MadAsHellAnd]

I believe this is a reliable report of whether there actually is QT; tell me if it's not or if there's more to the story.
http://bit.ly/2qWjcE6
Viewing the page as loaded (if the "From" box still shows 2007-07-30 when you open it) you see that since 2014 there has maybe been microscopic QT.

Type 2014-09-01 in the "From" box and hit enter. You can see "some" QT. Maybe so far just call it "non-QE" since 2014. So far, we can all "take comfort" at least that there has been non-QE since 2014. But ... whoop de do, as to the effect to date. Microscopic. If there really is such thing as -50B per month that will do SOMETHING - but so far, not so much (again, type 2007 in the "from" box for a view from the sky).

Personally speaking, I don't care WHEN they undo it. There's no such thing as mistaken timing to me for an unwind. They are doing, and have done, nothing but tampering and destroying rationality in markets. They're not protecting the integrity of the system, OR unemployment or the rate of inflation. Undo the whole gig tomorrow, and let there actually be free markets which will most efficiently and certainly rationally create prosperity. If they truly did a reset, everyone would have to take first their medicine to pay for the sins - as they should, and eventually must anyway after severe can-kicking. But what a wonderful world it would [finally] be. Personally speaking. Instead, though, one day, as we're all walking around as mutant zombies, if you stop moving you will hear a faint cry in the distance: "Why didn't we listen to Ron Paul? End...the...Fed."

[freedom 101]

Ext tec, if you are interested in understanding the workings of the cartel banking system, go to U Tube and check out Lynette ZANG and Karen HUDES. Both are very knowledgeable of the inner working of the financial system. Any assets recorded digitally can disappear, including the money in your bank accounts. Hyperinflation would result and even your cash would become greatly devalued.
Money market funds can be frozen and made unavailable for redemption as this pipe line of cash is mostly used by corporations as a source of short term lending.
If they go bankrupt those funds are lost, ie. Lehman in 2008. That is why the Too Big to Fail
banks were given trillions of dollars to capitalize their collective bad debts and keep their solvent.

The Bail- Ins have already been signed into law. Your bank deposits will be the last to receive compensation, the first creditor will be for the derivative products contracts. The top 1% always take their share first and leave the rest holding the bag of debts.

The NWO is very aware of what they are doing. However, when Trump got elected that set their agenda back about 20 years. Now they have to wait until he is out of office and a puppet can be elected President who will do their bidding. With Trump in office, they fear prosecution and the threat of going to jail. You may not like Trump, but so far he is causing chaos in the Swamp.

[dhughes327]

To me it doesn’t seem too hard to stay on the sidelines with cash until the Fed stops QT due to the resulting disaster and then jump into TLT & SPY. It should take less than a year for this to unfold.

[User 48470509]

Except TLT has probably already priced this in, no? Short bonds has become crowded, making a contrarian play possible. Which would mean bonds, safer stocks, and fixed income, then jump into SPY later.

[Humble Eagles]

We haven't had a recession in most of our lifetimes without the Fed raising rates to at least 5%, every recession in the last 50 years. Even if you go back and look at the recessions in the 50s, they were a couple of points north of current rates. '53 was the only exception, but even it was about 2%, and it followed a very long period of astronomical growth rates and much lower unemployment rates. We are just now getting the huge tax cuts taking effect for corporations and families with kids. I agree that predicting the future is tough work!

[fishfryer]

Bloomberg touched on this recently, but didn't connect the dots.

https://bloom.bg/2G0RnQj

If you overlay Fed rate hikes with the 10-2 vs recessions in the article, I believe see something like the Fed raising rates right up to recession even though the yield curve is inverted . Their reasons may be to suppress inflation... but I doubt they are that blissfully unaware how of their actions have caused recessions in the past decades.

[freedom 101]

"Why is the Fed the last to know" NONSENSE - should read why is the public the last to know."
The Fed and ALL Central Banks are privately owned institutions printing fiat money out
of thin air and then selling it back to Governments with interest, a ponzi scheme that could go on forever.
QE was introduced only to bail out the banks which they need to preserve so the scheme can
go on forever. The trillions of bad debt in the form of derivatives asre still on those bankers balance sheets and thebanks are bankrupt because of insufficient capitalization. Now QT to sell off assets. It makes perfect sense when you realize the big picture. The picture that most
of the public are not aware of. This is the shadow banking system and the New World Order that
wants an economic collapse and controls us globably. They will be the only ones left with reserves to buy back everything for pennies, (the purpose of the IMF). The policies and plans of the Federal Reserve and Central Banks makes perfect sense as to what they are doing. Wake up people, if you want the truth you need to read and educate yourself to alternatives news reports.

[brainleft]

freedom 101, precisely my viewpoint. The Fed makes zero mistakes and they dam sure don't work for us.

[Ext tech]

OK Freedom I can agree on much of what you say here. Based on this theorem and what we expect the feds to do in the upcoming months, how must we react to better position ourselves for what is to come?

[AlexTheCat3741]

freedom 101 - The situation that you describe was foretold more than two hundred years ago:

"If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their Fathers conquered.... I believe that banking institutions are more dangerous to our liberties than standing armies.... The issuing power should be taken from the banks and restored to the people, to whom it properly belongs." - Thomas Jefferson

[dhughes327]

It seems apparent that the Fed will do exactly what you are predicting which will cause a short-term spike in bond yields (bad for TLT & GLD), a significant drop in market prices (bad for SPY), and finally a reversal of QT which will be good for TLT, GLD, & SPY. What I don’t understand is why you don’t side step the short-term whipping and wait for the drop before going long TLT, GLD, & SPY?

[Eric Basmajian]

I am not in the timing game. If you believe you can exit TLT before the drop, enter near the bottom and re-exit after a rally then by all means but I certainly cannot.

I do not know the day TLT will bottom. Perhaps the low on Feb 21 for TLT was the low? If I got out now with the low in the rearview mirror, that would be foolish.

I don't have any way of telling when bonds or rates will bottom, to the day. It is not my strategy and I don't believe anyone can time the market that way, despite what they are trying to sell.

I will accumulate a position now, at the weighting assigned, which will more than compensate when the position reverses.

[Formerly_User_48537916]

Hi dhughes,

Good luck on timing long term interest rates. It's affected by so many exogenous and endogenous economic factors, that it is not possible to time it. If it were possible to model it, we would all be billionaires.

The extremely wealthy are privy to information that we don't have ,and they have a better shot at timing it than the average investor. But even then, there's always some unforeseen economic event that eventually throws a massive wrench into the timing.

[Diego Montalbon, raconteur]

This narrative might be more convincing if the author presented an explanation
of why, in the 2nd graph showing M2 Growth% from 1998 - 2017 , the
2002-2004 behavior which seems similar to the 2015-2017 behavior
was a policy mistake as well. If not then one can't help but question
the consistency of the view presented.

[David Sebastian]

"the Federal Reserve is selling assets." They are?

[Just Some Guy]

>The Federal Reserve is tightening monetary policy

No, not really. They are undoing some of the crazy stuff they have been doing since 2008 - and should have unwound by about 2010.

>when growth is slowing,

No, not really. And it's not growth you need to track, it's merely activity. It's not "growth" when it's still in recovery from 2008 - although much of the previous high was "balloon" and should not really be in the baseline anyway.

>a policy mistake.

Fed has been out of policy, in good ways and bad ways, since ... well, what "policy" do you think they've been following anyway? Their original policy was keeping the dollar "stable". Then in the 1980s (90s?) they had a new mission added, "full employment". But only an academic economist would think the Fed has any tools at all, to affect employment, in reality they do not. So what do you think their policy is, and how do you think they've done on it in the last ten years?

They are merely trying to get back to some degree of normality. And even this they cannot really do because of the $21t debt, they CANNOT raise rates to normal ranges. Unless and until they do some really crazy stuff that will cause many angry, puzzled, and confused editorials like this one.