Paul Kasriel, The Econtrarian

eFocus @ Legacy

July 2014

Author: Paul KasrielSenior Economic and Investment Advisor

The Wind Is at the Economy's Back for the Remainder of 2014

The U.S. economy bounced back as it thawed out from the severe winter. This rebound is not surprising given the strong growth in credit created, figuratively out of thin air, by depository financial institutions (primarily, commercial banks) and the Federal Reserve. A reasonable estimate of growth in this thin-air credit over the remainder of 2014 suggests that the economy should continue to grow at a healthy pace through the end of the year. But 2015 looks to be a more challenging year for the economy.

As a little review, both depository institutions (banks, S&Ls and credit unions) and the Fed have the unique ability to create credit figuratively out of thin air. Although borrowers could care less how their credit is created, it makes a difference to the overall economy. When credit is created out of thin air, no other entity needs to cut back on current spending as borrowers increase their current spending. Hence, there is a strong presumption that an increase in the sum of Fed and depository institution credit will result in a net increase in spending in the economy - spending on goods/services, physical assets and/or financial assets. The long-run relationship between changes in total thin-air credit and changes in nominal gross domestic purchases of goods and services has a correlation coefficient of positive 0.63. If thin-air credit and domestic purchases were to move in perfect tandem, the correlation coefficient would be 1.00. The principal reason they are not perfectly correlated is that spending on existing assets - physical or financial - is not included in gross domestic purchases. At the end of Q1:2014, total thin-air credit was up 8.4% versus the year-ago quarter. The median year-over-year growth in total thin-air credit is 7.2%.

Although the Fed is paring back its thin-air credit creation by reducing the amount of securities it purchases outright as it closes down its quantitative-easing program, commercial banks are stepping up their thin-air credit creation. As of May 2014, the year-over-year growth in the sum of Fed and break-adjusted commercial bank credit (let's call this "core" thin-air credit) had moderated to 8.5% vs. 9.2% in December 2013. (Break-adjusted commercial bank credit modifies bank credit when commercial banks acquire the assets of other types of depository institutions.) Growth in core thin-air credit is projected to moderate further to 8.0% by the end of 2014. Mind you, 8.0% annual growth in core thin-air credit is not slow in an historical context given that its 38-year median annualized growth is 7.1%. The projection of Fed credit is based primarily on the Fed's announced current plan to have eliminated its outright net purchases of securities by November 2014. The projection of break-adjusted commercial bank credit is based on the assumption that it will continue to grow at the 7.4% annualized pace that it has grown in the five months ended May 2014.

The expected moderation in thin-air credit growth is desirable if a significant acceleration in inflation is to be avoided. The reference to inflation includes not only the prices of goods and services but also the prices of assets, such as equities. Current CPI data suggests that the pace of consumer price inflation, although still relatively benign, has started to accelerate since February of this year. Although there is no consensus as to whether equity prices in general are trading at over-valued levels, there is no dispute that equity prices remain in an upward trend.

Looking further to the end of 2015, the projected annual growth in core thin-air credit shows a continued deceleration to 5.5%. Although this below-median growth would dampen inflationary pressures, such an abrupt slowing in core thin-air credit also could result in an abrupt slowdown in the growth of real economic activity, albeit not of a recessionary magnitude. If the projection for core thin-air credit growth turns out to be close to the mark, 2015 could be a challenging year for both economic activity and equity markets.