Category Archives: Money

Has The Fed Been Raising The Fed Funds Rate Under The Radar?

By Jeffrey J. Peshut

March 26, 2015

At its March 18th meeting, the Federal Open Market Committee (“FOMC”) withdrew its pledge to be “patient” about raising the Fed Funds Target Rate above its current target range of 0 to 25 basis points, thus ending “forward guidance” about its policy stance and allowing the FOMC more freedom and flexibility about the timing of a rate increase.   The FOMC indicated that as long as the employment market continues to improve, the FOMC will raise the Fed Funds Target Rate once it becomes “reasonably confident” that inflation will approach 2% over the medium term.  The FOMC added that a rate increase remained “unlikely” at its April meeting and said its change in rate guidance does not mean it has decided on the timing for a rate hike.  Fed Chair Janet Yellen later told reporters that a June move could not be ruled out.

Notwithstanding the FOMC’s statement – and despite the keen attention paid to it by Fed watchers — one question that no one seems to be asking is whether the Fed has already been raising the Fed Funds Rate under the radar.  This post addresses that question.  Before addressing it, however, let’s first review some monetary policy basics.

Monetary Policy and Policy Tools

The Federal Reserve uses monetary policy to influence the supply of money and credit in the U.S. economy.  The supply of money and credit, in turn, affects interest rates and the performance of the U.S. economy and financial markets.

Traditionally, the Federal Reserve has used three tools to implement its monetary policy:

  • Fed Funds Rate – The average rate at which a depository institution (DI) — or other eligible entity such as a foreign bank or government sponsored enterprise — makes an unsecured overnight loan of U.S. dollars to another DI (“Fed Funds Transaction”). A DI borrows money overnight from another DI to maintain its reserve balances or clear financial transactions.
  • The Discount Rate – The rate charged by Federal Reserve Banks to depository institutions (DIs) on short-term loans.
  • The Reserve Requirement – The reserve requirement is the percentage of its customer deposits that each DI must hold as reserves – rather than lend out – either in their vaults or on deposit at a Federal Reserve Bank.

Since October of 2008 the Fed has been using the payment of interest on reserves as a fourth policy tool and from December of 2008 to October of 2014 the Fed used Quantitative Easing (“QE”) as a fifth tool.

Up until the fourth quarter of 2008 — when the Fed adopted a Zero Interest Rate Policy (ZIRP), reduced the Fed Funds Target Rate to nearly zero, began paying interest on reserves and initiated QE – raising and lowering the Fed Funds Rate had been the Fed’s primary policy tool.  To implement its monetary policy, the FOMC would set a target level or range for the Fed Funds Rate consistent with the desired level of reserves and then use its open market operations to influence the reserve balances until the Fed Funds Effective Rate reached its target rate.

The Fed’s open market operations influence reserve balances by purchasing and selling financial instruments — which are usually securities issued by the U.S. Treasury, Federal agencies and government-sponsored enterprises (GSEs) — in the “open market”.   Open market operations are carried out by the Domestic Trading Desk of the Federal Reserve Bank of New York under direction from the FOMC.  The transactions are executed through a cadre of security dealers that the Fed regularly does business with, which are known as “primary dealers”.

When the Fed wants to increase reserves and thereby lower the Fed Funds Effective Rate, it buys securities and pays for them by making a deposit to the account maintained at the Fed by the primary dealer’s bank.  When the Fed wants to reduce reserves and thereby raise the Fed Funds Effective Rate, it sells securities and makes a withdrawal from these accounts.  Most of the time, the Fed does not want to permanently increase or decrease reserves, so it reverses these transactions within several days.

Figure 1 illustrates how changes in reserve balances influenced the Fed Funds Effective Rate from the beginning of 1985 through the third quarter of 2008.  When reserve balances decreased, the Fed Funds Effective Rate increased and when reserve balances increased, the Fed Funds Effective Rate clearly decreased.

Figure 1: Fed Funds Effective Rate (%/Yr) v. Reserve Balances (YOY%)  01-01-85 to 09-01-08

Fed Funds Effective Rate v. Reserve Balances YOY 01-01-85 to 09-01-08

How Did Quantitative Easing Impact Reserve Balances?

Once the Fed lowered the target Fed Funds Target Rate into the 0 to 25 bps range, QE replaced the Fed Funds Rate as the Fed’s primary policy tool.  The impact on reserve balances was both immediate and remarkable.  (See Figure 2.)  Because the increase was so great, I’ve used a panel chart to be able to see the reserve balances before QE and the reserve balances after QE on the same chart.

Figure 2: Depository Institution Reserve Balances at Federal Reserve Banks ($Billions) 01-01-84 to 02-01-15

Reserve Balances at Federal Reserve Banks 01-01-84 to 02-01-15

Reserve balances went from $847.82 billion at the beginning of QE1 in December of 2008 to $1.12 trillion at the end of QE1 in March of 2010, to $1.62 trillion at the end of QE2 in June of 2011 and to $2.63 trillion at the end of QE3 in October of 2014.

The greatest increase in reserves on a on a year-over-year percentage basis actually occurred in the year leading up to QE1 when reserve balances went from a mere $5.67 billion in December of 2007 to the previously mentioned $847.82 billion in December of 2008, a head-spinning year-over-year increase of over 14,800%!  (See Figure 3.)  Again, a panel chart allows us to see the year-over-year percentage change before QE and the year-over-year percentage change after QE on the same chart.

Balances at Federal Reserve Banks (YOY%) 01-01-85 to 02-01-15

Reserve Balances at Federal Reserve Banks YOY 01-01-84 to 02-01-15

Why Did The Fed Start Paying Interest On Reserves?

The aggressive expansion of the Fed’s various liquidity facilities caused a large increase in excess reserve balances that placed extraordinary downward pressure on the Fed Funds Effective Rate.  This made it difficult for the Fed to achieve the operating target for the Federal Funds Rate set by the FOMC.  According to the Fed, paying interest on reserves allowed it to increase the level of reserves and still maintain control of the Federal Funds Rate.

Because depository institutions have little incentive to lend in the overnight inter-bank Fed Funds market at rates below the interest rate on excess reserves, paying interest on reserves allows the Fed to effectively place a floor on the Fed Funds Rate.  This floor allows the Fed to keep the Fed Funds Effective Rate closer to its target rate than it would have been otherwise able to.

Some commentators argue that once the Fed began paying interest on reserves and reduced the Fed Funds Target Rate to a range of 0 to 25 bps, it effectively decoupled changes in the Fed Funds Effective Rate from changes in reserve balances in the banking system.  They say that the Fed can now adjust reserve balances independently of the Fed Funds Effective Rate and that therefore the Fed Funds Rate is no longer a relevant policy tool.  As a result, they believe that the keen attention that people are paying to the timing of the Fed’s increase in the Fed Funds Rate is misplaced.

At first glance, Figure 4 would seem to support these commentators’ argument.  From December 2008 until today, the Fed Funds Effective Rate has been range bound between 0 and 25 bps while reserve balances have been growing at exponential rates.

Figure 4: Reserve Balances (YOY%) v. Fed Funds Effective Rate (%/Yr) 01-01-85 to 02-01-15

Fed Funds Effective Rate v. Reserve Balances YOY 01-01-85 to 02-01-15

If we zoom into the portion of the chart that relates to the period after QE1, which ended in March of 2010, we see that the relationship between changes in reserve balances and changes in the Fed Funds Effective Rate is as strong as it has ever been.  (See Figure 5.)  The changes in the Fed Funds Effective Rate are just occurring on a much smaller scale!

Figure 5: Reserve Balances YOY% v. Fed Funds Effective Rate (%/Yr) 04-01-10 to 02-01-15

Fed Funds Effective Rate v. Reserve Balances YOY 04-01-10 to 02-01-15

We also see that the Fed’s “Taper” policy that began at the beginning of 2014 has reduced reserve balances from a high of $2.8 trillion in July of 2014 to $2.3 trillion in February of this year — a reduction of 18% in eight months.  This decrease in reserve balances has raised the Fed Funds Effective Rate from 7 bps in January of 2014 to 11 bps in February of this year — an increase of more than 57% in a little over a year.

So, to answer the question raised at the beginning of this post, the Fed has indeed been raising the Fed Funds Effective Rate under the radar since January of 2014.  They’ve just been using the tapering of Quantitative Easing to reduce reserve balances instead of the more traditional method of raising the Fed Funds Target Rate.

What’s Next For Reserve Balances and The Fed Funds Rate?

To continue to raise the Fed Funds Effective Rate, watch for the Fed to reduce reserve balances in the months ahead.  It’s unlikely that the Fed will begin to raise the Fed Funds Target Rate until the Fed Funds Effective Rate approaches 25 bps, the upper limit of its current target range for the Fed Funds Rate.  Once the Fed does raise the Fed Funds Target Rate, the Fed Funds Rate should retake its place as the Fed’s primary policy tool and we’ll once again be able to pick up changes in the Fed Funds Rate on our radar screens.

When Will The Fed Begin Raising The Fed Funds Rate?

By Jeffrey J Peshut

December 20, 2014

In its press release about its December 17th meeting, the Federal Open Market Committee (“FOMC”) shifted its language about how long it will maintain the target Fed Funds Rate in the 0 to 1/4% range from “considerable time” to “it can be patient”.

Most Fed watchers have been focused on the first increase in the Fed Funds Rate as the sign that the Fed has shifted from a loose policy stance to a tight policy stance.  I suggest that the “Taper” that began in January of this year and the end of Quantitative Easing in October were the first phases in a type of monetary tightening that we haven’t seen during our lifetimes and that the tightening everyone has been watching for has been hiding in plain sight throughout 2014.

That said, the Fed’s shift in language is a sign that, for the time being, the Fed is committed to a tighter policy stance and a clue about when the next phase of tightening will begin.  Based upon language used by the FOMC in the past, here is how the Fed’s words translate into time:

“Considerable Time” = 6 – 10 months

“It Can Be Patient” = 2 – 5 months

“Measured Approach” = 1 month

Applying this translation to the current situation, it looks like the FOMC will start raising the Fed Funds Rate at its scheduled meeting in April of 2015.  Of course, even though it is unlikely, the Fed could shift its language and policy stance again between now and April.  If it does, RealForecasts.com will provided an updated forecast based upon the new information.  So, keep checking back with RealForecasts.com for the latest news about the Fed’s actions and what they mean to investors in real assets.

What Is So Good About Gold?

By Jeffrey J. Peshut

December 7, 2014

Warren Buffett — who  is the second-wealthiest man in the U.S. with a net worth of $72.7 billion according to Forbes.com — once said this about gold:

Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

If the country’s second-wealthiest man has such antipathy toward it, what is so good about gold?  Before attempting to answer that question, let’s first take a look at what gold is and what it isn’t.

What Is Gold?

Despite Warren Buffett’s remark about head-scratching Martians, there is nothing mysterious about gold. Scientifically speaking, gold is a chemical element with the symbol Au and the atomic number of 79 — between platinum (Pt) and mercury (Hg) and directly below silver (Ag) on the Periodic Table of Elements. (See Figure 1.)  It is a bright yellow dense, soft, malleable and ductile metal.

Figure 1: Periodic Table of the Elements

Periodic Table of Elements.jpg

People first mined gold about 5,000 years ago.  Since that time, we have valued gold for emotional, cultural, political and economic reasons.  Because of its emotional, cultural and political significance, gold has been the subject of many beliefs and false beliefs.  Although this post will focus on gold’s economic aspects, it will also attempt to dispel some of the confusion and false beliefs surrounding it.

Economically, gold is classified as a commodity, similar to other precious metals such as platinum and silver.  According to the World Gold Council, there were 177,200 tonnes of gold stock in existence above the ground at the end of 2013.

Approximately 3,000 tonnes of new gold is mined each year, an increase in the gold stock of only 1.5% to 2.0% per year.  East Asia as a whole produces 21 per cent of the total of newly-mined gold.  (China is the largest single gold-producing country in the world, accounting for around 14 per cent of total production.)  Latin America produces around 18 per cent of the total, with North America supplying around 15 per cent.  Around 19 per cent of production comes from Africa and 5 per cent from Central Asia and Eastern Europe.

On average, 45 to 50% of the gold purchased each year is fabricated into jewelry, 30% to 35% of the gold purchased is acquired for investment purposes, 10% is purchased for manufacturing in technology and 10% is purchased by Central Banks for their reserve portfolios.  During 2013, 2,370 tonnes of gold were purchased for jewelry fabrication (55.7%), 1,069 tonnes were purchased for investment (25.1%), 408 tons were purchased for technology manufacturing (9.6%) and Central Bank net purchases accounted for 409 tonnes (9.6%).  (See Figure 2.)

Figure 2: Gold Purchases 2013

Gold Purchases - 2013

Is Gold Money?

Much of the confusion surrounding gold today stems from its historical role as money.  The World Gold Council provides a comprehensive overview of gold’s role in the monetary system.  A summary of the WGC’s overview follows.

Gold coins were first struck on the order of King Croesus of Lydia (an area that is now part of Turkey around 550 BC.  Gold coins circulated as currency in many countries before the introduction of paper money.  Once paper money was introduced, currencies still maintained an explicit link to gold, with the paper being exchangeable for gold on demand.  By the late 19th Century, many of the world’s major currencies were fixed to gold at a set price per ounce, under the so-called Gold Standard.

Under the Gold Standard, nearly all countries either fixed the value of their currencies in terms of a specified amount of gold, or linked their currency to that of a country that did so.  Domestic currencies were freely convertible into gold at the fixed price and there was no restriction on the import or export of gold.  Gold coins circulated as domestic currency alongside coins of other metals and notes, with the composition varying by country.  Because each currency was fixed in terms of gold, exchange rates between participating currencies were also fixed.

The classical Gold Standard existed for only about 40 years — from the 1870s until the outbreak of World War I in 1914.  By 1900 all countries apart from China, and some Central American countries, were on a Gold Standard.

The Gold Standard broke down at the outset of WW I as countries resorted to inflationary policies to finance the war and, later, reconstruction efforts.  In practice, only the U.S. remained on the gold standard during the war.  Periodic attempts to return to a pure classical Gold Standard were made during the inter-war period, but none survived past the Great Depression.

During World War II, many believed that a new international system would be needed after the war ended to replace the Gold Standard.  The design for the new system was drawn up at the Bretton Woods Conference — named after the town in New Hampshire in which it took place —  in 1944.  The Bretton Woods system fixed the dollar to gold at the existing parity of US$35 per ounce, while all other currencies had fixed, but adjustable, exchange rates to the dollar.

In March 1968, a two-tier gold market was introduced with a freely floating private market, but with official transactions at the fixed parity of US$35 per ounce.  Finally in August 1971, President Nixon announced that the U.S. would end on-demand convertibility of the dollar into gold for the central banks of other nations.  The Bretton Woods system collapsed and gold traded freely on the world’s markets.

To determine gold’s status as money today, we must first define money.  According to Austrian School economists, the defining characteristic of money is its use as a medium of exchange.  If Austrian School economists considered gold to be a medium of exchange today, they’d be including it in their calculation of the money supply.

As explained by RealForecasts in its last post, however, the Austrian money supply — which RealForecasts.com refers to as the True Money Supply — is made up of Base Money and Uncovered Money Substitutes.  Base Money is made up of Currency Outstanding and Reserve Deposits held by the Fed.  The Uncovered Money Substitute portion of the money supply is money created by the “pyramiding” of Reserve Deposits through fractional reserve banking.  (See Figure 3.)

Figure 3: Base Money and Uncovered Money Substitutes ($ Billions) 01/01/05 – 09/01/14

Base Money and Uncovered Money Substitutes 01-01-05 - 09-01-14

During periods in which gold coins circulated as part of a country’s currency and these currencies were freely convertible into gold held by central banks at a fixed price under the Gold Standard, gold was used a medium of exchange, was part of Base Money and thus was a part of the money supply.  Gold was money.

Today, gold coins are no longer circulating as currency and are therefore no longer a medium of exchange.  Further, since the collapse of the Bretton Woods System, gold is no longer part of Base Money and therefore is not part of the money supply.  As a result, it is no longer accurate to characterize gold as money.

All that said, many investors purchase gold as a hedge against the debasement and possible collapse of a fiat currency.  They believe that gold will regain its status as money If the fiat currency collapses.  Because of gold’s potential to become an integral part of the monetary system once again, a case can be made to characterize gold as “contingent money”.

Is Gold A Good Investment?

In investment circles, gold is categorized as a “real asset” as compared to a “financial asset”.  Real assets are physical or tangible assets that have value, due to their intrinsic qualities and properties. Real assets include precious metals like gold, commodities, real estate, agricultural land and oil.  Financial assets or “paper assets” derive their value from a contractual claim. Stocks, bonds and bank deposits are all examples of financial assets.

So is gold a good investment?  Since 1978, the price of gold has reported an average increase of 8.52%, year-over-year.  (See Figure 4.)

Figure 4: Gold Price (YOY%) 1/1/78 – 10/31/14

Gold Price - YOY 1978 - 2014

Whether an asset is a good investment, however, depends upon a number of factors such as the investor’s investment style, risk tolerance, investment time horizon and investment objectives.  For example, Warren Buffett is generally known as a buy-to-hold “value investor” in the tradition of Benjamin Graham and David Dodd.  As the name suggests, value investors buy financial assets that appear under-priced based upon some form of fundamental analysis.  It’s not surprising that a value investor like Buffett would eschew a real asset like gold.

On the other hand, diversified investors who follow the tenets of Modern Portfolio Theory — as pioneered by Harry Markowitz in the 1950s — are attracted to real assets like gold because they lack correlation with financial assets, which allows them to diversify their portfolios and reduce portfolio volatility.  Still other investors choose gold as a hedge against both inflation and currency risk.  Gold’s usefulness as a hedge against currency risk is illustrated in Figure 5.

Figure 5:  Gold Price (YOY%) v. US Dollar Index (YOY%) 1/1/78 – 10/1/14

Gold Price v. US Dollar Index - YOY - 1-1-78 - 10-1-14

Note the very strong inverse correlation between the growth rate of the gold price and the growth rate of the price of the U.S. Dollar relative to other major currencies.

U.S. Dollar Index and Gold Price Forecasts

Consistent with Austrian Business Cycle Theory, we can use the growth rate of TMS to forecast the growth rate of both the U.S. Dollar Index and Gold Price.  The very strong inverse correlation between the growth rate of the U.S. Dollar Index and the growth rate of the True Money Supply (TMS) is shown in Figure 6.

Figure 6: U.S. Dollar Index (YOY%) v. True Money Supply (YOY%) 1/1/78 – 10/01-14

US Dollar Index v. True Money Supply - YOY - 01-01-78 - 10-01-14

If the Fed expands the U.S. money supply at a faster rate than the central banks of the countries of other major currencies expand their money supply, the laws of supply and demand suggest that the price of the U.S. Dollar should fall relative to the other currencies (all else being equal).  Conversely, if the Fed expands the U.S. money supply at a slower rate than the other central banks expand their currencies, the price of the U.S. Dollar should rise relative to the other currencies.  The chart in Figure 6 certainly supports these suggestions.

In its previous post, RealForecasts,com forecasted the continued deceleration in the growth of TMS through the end of 2016.  If during the same period the European Central Bank, Japanese Central Bank and others accelerate the growth of TMS for their currencies, look for the US Dollar to continue to strengthen and the US Dollar Index to continue to rise.  (See Figure 7.)

Figure 7: US Dollar Index (YOY%) v. True Money Supply (YOY%) 1/1/78 – 10-01-14 Actual and 11/01/14 – 12/31/16 Forecast

US Dollar Index v. True Money Supply - YOY - Forecast 11-01-14 - 12-31-16

Because of the strong inverse correlation between the price of gold and the U.S. Dollar Index, when the U.S. Dollar strengthens and the U.S. Dollar Index rises, the Gold Price will likely fall.  (See Figure 8.)

Figure 8:  Gold Price (YOY%) v. US Dollar Index (YOY%) 1/1/78 – 10/1/14 Actual and 11/01/14 – 12/31/14 Forecast

Gold Price v. US Dollar Index - YOY - 11-01-14 - 12-31-14 Forecast

When the next financial crisis occurs, however, watch for the Gold Price and the U.S, Dollar Index to reverse, with the growth rate of the U.S. Dollar Index decelerating and even decreasing and the growth rate of the price of gold accelerating sharply.

This forecast is not only predicated on the Fed continuing its current policy stance, but also on the other major central banks continuing their policy stances.  In the event the Fed or the other central banks adjust their policy stances, it will alsbe necessary to adjust this forecast in light of the changed policies.  Continue to check back with RealForecasts.com for future updates.

As always, thanks to J. Michael Pollaro, author of The Contrarian Take, for the TMS data used to construct the charts in this article.  To see more of Michael’s TMS data, go to http://blogs.forbes.com/michaelpollaro/austrian-money-supply/.

How Will The End Of Quantitative Easing Impact The True Money Supply Growth Rate?

By Jeffrey J. Peshut

November 11, 2014

On Wednesday October 29th, the Federal Open Market Committee (FOMC) directed the Open Market Trading Desk at the Federal Reserve Bank of New York to conclude its asset purchase program — commonly referred to as Quantitative Easing or QE for short — by the end of October.  The FOMC also directed the Open Market Trading Desk to maintain the existing policy of reinvesting principal payments from the Federal Reserve’s holdings of both agency debt and agency MBS into agency MBS and of rolling over maturing Treasury securities at auction. Now that QE has ended, RealForecasts.com will look back to see the impact it has had on the growth and growth rate of the True Money Supply (TMS) and then provide a forecast of the TMS growth rate between now and the end of 2016.

The Impact of Quantitative Easing on the Growth Rate of the True Money Supply

Since it began in November of 2008, the Fed’s QE policy has had a dramatic impact on the growth of the TMS.  TMS grew from approximately $5.6 trillion in November of 2008 to almost $10.5 trillion at the end of September of this year — an increase of over $800 billion per year.  (See Figure 1.)

Figure 1: True Money Supply ($ Billions) 1/1/05 – 9/1/14 True Money Supply ($Billions) 01-01-05 - 09-01-14This represents an increase in TMS of 87.5% over 70 months or an average increase of 15% per year.

The growth of TMS accelerated sharply from November of 2008 to November of 2009 and from November of 2010 to August of 2011. These two periods correspond to the periods of QE1 and QE2, respectively.  Between September of 2011 and December of 2013 — the period of QE3 — TMS growth decelerated, but then grew at a relatively constant rate of approximately 8% YOY during the Fed’s QE3 “Taper” policy that began in January of this year and just ended in October.  (See Figure 2.)

Figure 2: True Money Supply (YOY%) 01/01/05 – 09/01/14 True Money Supply - YOY - 01-01-05 - 09-01-14

True Money Supply Forecast

To forecast the growth rate of TMS in a post-QE economy, we need to first separate TMS into its two component parts — Base Money and Uncovered Money Substitutes.  As explained in Is True Money Supply (TMS) Growth Continuing To Decelerate?, Base Money is made up of Currency Outstanding and Reserve Deposits held by the Fed — also known as Covered Money Substitutes.  The rate of growth of Base Money is directly related to the level of bond-buying activity by the Fed. The Uncovered Money Substitute portion of TMS is money created by the “pyramiding” of Reserve Deposits through fractional reserve banking.  The rate of growth of Uncovered Money Substitutes is directly related to the level of lending by the commercial banks.

Base Money (Currency and Covered Money Substitutes) and Uncovered Money Substitutes from January of 2005 through September of 2014 are shown in Figure 3.  The impact of the Fed’s bond-buying activity on the growth of Base Money is clearly visible in the growth of Covered Money Substitutes beginning in November of 2008.

Figure 3: Base Money and Uncovered Money Substitutes ($ Billions) 01/01/05 – 09-01-14

Base Money and Uncovered Money Substitutes 01-01-05 - 09-01-14

During the almost six-years of Quantitative Easing, three periods of accelerating growth of Base Money stand out — from November of 2008 to September of 2009, from November of 2010 to August of 2011 and from September 2012 to November of 2013.   (See Figure 4.)  The first period corresponds to most of QE1, while the second and third periods correspond directly to the periods of QE2 and QE3, respectively.

Figure 4: Base Money (YOY%) 01/01/05 – 09-01-14 Base Money YOY 01-01-05 - 09-01-14

Under a fractional reserve banking system, we’d expect that an increase in Base Money caused by an increase in Covered Money Substitutes — or Reserve Deposits — under QE would generate an increase in lending activity by commercial banks — which in turn would generate an increase in Uncovered Money Substitutes.  That is exactly what happened under QE1 and QE2, and has begun to happen under QE3. (See Figure 5.)

Figure 5: Base Money and Uncovered Money Substitutes (YOY%) 01/01/10 – 09-01-14 Base Money and Uncovered Money Substitutes 01-01-05 - 09-01-14

Notice that the peak in the growth rate of Uncovered Money Substitutes lagged the peak in the growth rate of Base Money by 18 months after QE1 and by 9 months after QE2. The last peak in the rate of growth of Base Money occurred 12 months ago, in November of 2013.  If we assume that the growth rate of Uncovered Money Substitutes lags the peak in the growth rate of Base Money by 18 months — the longer and more conservative of the periods after QE1 and QE2 — then the growth rate of Uncovered Money Substitutes should peak in mid-2015.  (See Figure 6.)

Figure 6: Base Money and Uncovered Money Substitutes (YOY%) 01/01/10 – 09-01-14 Actual and 10/1/14 – 12/31/16 Forecast Base Money and UMS Forecast 10-01-14 - 12-31-16

During the first nine months of 2014, the acceleration of lending activity by commercial banks has more than offset the deceleration of the Fed’s bond-buying activity under the QE3 Taper, which explains why the growth rate of TMS during 2014 has held constant at about 8% in the face of the Base Money’s decelerating growth.  Once the rate of growth of Uncovered Money Substitutes peaks, however, the TMS growth rate will once again decelerate, approaching 0% by the end of 2016.  (See Figure 7.)

Figure 7: True Money Supply (YOY%) 01/01/10 – 09-01-14 Actual and 10/01/14 – 12/31/16 Forecast True Money Supply - YOY - Forecast 10-01-14 - 12-31-16

So, for now, it looks like the TMS growth rate will remain constant or may even accelerate slightly through mid-year 2015, at which point it will turn downward and continue downward through the end of 2016.  Of course, this forecast is predicated on the Fed continuing its current policy stance.  In the event the Fed changes its stance, all bets are off and it will be necessary to adjust this forecast in light of the changed policy.  Continue to check back with RealForecasts.com for future updates about changes in the TMS growth rate.

As always, thanks to J. Michael Pollaro, author of The Contrarian Take, for the TMS data used to construct the charts in this article.  To see more of Michael’s TMS data, go to http://blogs.forbes.com/michaelpollaro/austrian-money-supply/.

Why Do Yield Curves of Treasury Securities Forecast Business Cycles So Well?

By Jeffrey J. Peshut

August 18, 2014

In a recent post on LinkedIn, economic strategist Paul Winghart correctly points out that yield curves of Treasury securities have an unrivaled track record of out-forecasting even the best economic forecasters — present company excepted, of course!  In support of his proposition, he cites “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve” (Rudebusch and Williams, 2008).  Mr. Winghart veers off track, however, when he echoes Keynesians like Fed Chair Janet Yellen and argues that the yield curves’ greatest powers are their ability to capture and reflect the amount of economic slack in the economy at any given moment.

This post will show that yield curves accurately forecast business cycles because they reflect the Fed’s manipulation of both interest rates and the supply of money and credit, not economic slack in the economy.  Therefore, Mr. Winghart presented the right chart, but with the wrong reasons for why it works.

This post will then go on to forecast the 10-Year Treasury/3-Month Treasury spread over the next 12 to 24 months and suggest the likely impact the forecasted spread wil have on the economy.

Yield Curves of Treasury Securities and Forecasting Business Cycles

The yield curves of Treasury securities — specifically the spread between yields of long-term and short-term Treasury securities — have a well-documented history of accurately forecasting business cycles in general and economic recessions in particular.  A case in point is the spread between the yield on the 10-year Treasury Note and the 3-Month Treasury Bill.  (See Figure 1.)

Figure 1: 10-Year Treasury Note to 3-Month Treasury Spread  01/01/82 to 07/01/14

10-Year Treasury to 3-Month Treasury Spread 01-01-82 to 07-01-14

Shortly before each of the last four economic recessions, the spread between the 10-Year Treasury Note and the 3-Month Treasury Bill approached zero and in the case of the last three recessions actually fell below zero.  Put differently, in each case the yield curve flattened and even inverted.  Any investor monitoring the yield curves or this chart could have easily seen the economic downturns far enough ahead to still have time to take the appropriate protective actions.

Why Do They Work So Well?

To understand why the yield curves of Treasury securities forecast business cycles so well, it’s necessary to first look at the yields on the long-term and short-term Treasuries side-by-side to see whether one or the other is more responsible for the widening and narrowing of the spreads.  (See Figure 2.)

Figure 2: 10-Year Treasury Note and 3-Month Treasury Bill  01/01/82 to 07/01/14

10-Year Treasury and 3-Month Treasury 01-01-82 to 07-01-14

You can see right away that, except for the early 1980s, yields on the 3-Month Treasury Bill have been much more volatile than yields on the 10-Year Treasury Note and that they have been much more responsible for changes in the spread than yields on the 10-Year Treasury.

Next, we need to look for a reason for the volatility in the 3-Month Treasury Bill.  Because the Federal Reserve is responsible for establishing short-term interest rates through its control of the Fed Funds Rate, comparing yields on the 3-Month Treasury Bill to the Fed Funds Rate is a good place to start.  (See Figure 3.)

Figure 3: 3-Month Treasury Bill and Fed Funds Rate  01/01/82 to 07/01/14

3-Month Treasury and Fed Funds Rate  01-01-82 to 07-01-14

Not surprisingly, yields on the 3-Month Treasury Bill move in virtual lock step with the Fed Funds Rate.  This suggests that the Fed is responsible for the volatility in the 3-Month Treasury Bill through its control of the Fed Funds Rate and, by extension, is also largely responsible for changes in the spread between the 10-Year Treasury Note and the 3-Month Treasury Bill.

Now, if the spread between the 10-Year Treasury Note and 3-Month Treasury Bill accurately forecasts recessions, changes in the yields of the 3-Month Treasury Bill are largely responsible for changes in the 10-Year Treasury Note/3-Month Treasury Bill spread and the Fed’s control of the Fed Funds Rate is responsible for changes in the yield of the 3-Month Treasury Bill, it follows that changes in the Fed Funds Rate should also accurately forecast recessions.

Here’s where Austrian Business Cycle Theory (ABCT) comes in.  Not only do changes in the Fed Funds Rate accurately forecast recessions, but the Fed’s manipulation of the Fed Funds Rate and yields on short-term Treasury securities actually causes the business cycle. That’s why the yield curves of Treasury securities forecast business cycles so well!   For a thorough explanation of how the Federal Reserve causes the business cycle, see an earlier post on RealForecasts.com titled “Does The Federal Reserve Really Cause The Boom/Bust Cycle?”

What’s Next For The Fed Funds Rate And The 10-Year Treasury/3-Month Treasury Spread?

As of July 1, the spread between the 10-Year Treasury and 3-Month Treasury was 2.51%.  (See Figure 1.)  Because the Fed’s manipulation of the Fed Funds Rate causes the business cycle — and economic recessions occur once the spread between the 10-Year Treasury Note and 3-Month Treasury Bill approaches zero — it’s important to forecast the Fed’s actions and the 10-year Treasury/3-Month Treasury spread in the months ahead.

To begin, the Fed isn’t expected to raise the Fed Funds Rate until it ends its current round of quantitative easing, commonly referred to as QE3.  In July, the Fed tapered its monthly bond buying to $25 billion and is on track to end QE3 in October of this year.

Next, the median estimate of Fed officials, released after the FOMC’s June meeting, forecasted an increase in the Fed Funds Rate to 1.13% at the end of 2015 and 2.5% by the end of 2016.  According to the median of economists’ estimates in a Bloomberg survey, the Fed will first increase the Fed Funds Rate to 0.50% after its July, 2015 meeting.  St. Louis Fed President James Bullard, who doesn’t vote on policy this year, has said that the Fed should increase the Fed Funds Rate at the end of March, depending on economic data.

Once the Fed begins raising the Fed Funds Rate, look for the 10-Year Treasury/3-Month Treasury to begin narrowing.  Because the spread is at 2.51% today, it’s likely that the Fed will have to raise the Fed Funds Rate by only 250 to 300 basis points before the spread approaches zero and the economy enters its next recession.  If the Fed officials’ forecast mentioned above is accurate, that could occur by the end of 2016.  (See Figure 4.)

Figure 4: 10-Year Treasury Note to 3-Month Treasury Spread  08/01/14 to 12/31/16 Forecast

10-Year Treasury to 3-Month Treasury Spread 08-01-14 to 12-31-16 Forecast

So, for now, it appears that the Fed will begin to raise the Fed Funds Rate, and thereby begin to narrow the 10-Year Treasury/3-Month Treasury spread, in mid-2015 — give or take a quarter.  It also appears that the Fed Funds Rate will reach 2.5%, the 10-Year Treasury/3-Month Treasury spread will approach zero and the economy will enter its next recession by the end of 2016.   Continue to check back with RealForecasts.com for future updates about changes in the 10-Year Treasury/3-Month Treasury spread.

Is True Money Supply (TMS) Growth Continuing To Decelerate?

By Jeffrey J. Peshut

July 16, 2014

In its most recent posts — What’s Next For Employment Growth?, Will GDP Growth Continue To Lose Momentum? and Where Will Commercial Real Estate Returns Go From Here? — RealForecasts.com showed that the rate of growth of TMS had been decelerating since September, 2011.  (See Figure 1.)

Figure 1: True Money Supply (YOY%) 1/1/06 – 12-01-13True Money Supply 01-01-06 to 12-01-13

Moreover, at the end of each of these posts, RealForecasts.com encouraged readers to continue to monitor the Fed’s actions during 2014 to anticipate changes in TMS.  To that point, it’s been widely publicized that the Fed has been reducing or “tapering” its bond purchases under QE3, from a high of $85 billion per month in November of 2013 down to $35 billion per month in July of 2014.   Based on a roughly $10 billion per meeting tapering schedule, the last QE3  purchases should occur in October of 2014.

As a result of the Fed’s tapering policy, I would have expected the growth rate of TMS to continue to decelerate during the first part of 2014.  I was surprised to learn instead that the TMS growth rate accelerated slightly during the first five months of the year.  (See Figure 2.)

Figure 2: True Money Supply (YOY%) 1/1/06 to 5/1/14True Money Supply 01-01-06 to 05-01-14

According to my Austrian fellow-traveler Michael Pollaro,  the recent acceleration in the growth of TMS can be explained by looking separately at the two sources of TMS — Base Money and Uncovered Money Substitutes.  Base Money is made up of Currency Outstanding and Reserve Deposits held by the Fed.  The rate of growth of Base Money is directly related to the level of the Fed’s bond-buying activity.

The Uncovered Money Substitute portion of TMS is money created by the “pyramiding” of Reserve Deposits through fractional reserve banking.  The rate of growth of Uncovered Money Substitutes is directly related to the level of lending by the commercial banks.

Data provided by Michael shows that the recent acceleration in lending activity by commercial banks has more than offset the deceleration in the Fed’s bond-buying activity.  It’s too early to tell whether this relationship will continue long enough to be characterized as the beginning of a trend.

Even if it doesn’t develop into a new trend, the interruption in the deceleration of TMS could delay by five or six months the events forecast by RealForecasts.com in recent posts.  Keep checking back with RealForecasts.com for future changes in the growth rate of TMS.

As always, thanks to J. Michael Pollaro, author of The Contrarian Take, for the TMS data used to construct the charts in this article.

Whence The Housing Bubble?

Editor’s Note: RealForecasts.com is re-publishing a blog post titled “Whence The Housing Bubble?”, originally posted by Joseph Salerno on Circle Bastiat on March 5, 2013.

At the end of 2012, the ratio of the average existing home sales price of $225,400 to the average household income of $71,274 equaled 3.16, less than its long-term average of 3.21.  Through the first three quarters of 2013, the average existing home sales price had increased to $243,233.  Average household income for 2013 is not yet available.  Even if we’re conservative and assume that average household income increased by only 1.5% through the first three quarters of 2013, the ratio has increased to only 3.36, slightly greater than the long-term average but well below the level reached at the height of the Housing Bubble.

Whence The Housing Bubble?

By Joseph Salerno

March, 2013

I have recently written that there are certain key indexes and ratios derived from Austrian business cycle theory that help us discern the development of bubbles in various sectors. As Mises wrote: “Only theory, business cycle theory, permits us to detect the wavy outline of a cycle in the tangled confusion of events.”

Jeff Peshut, an institutional real estate investment manager, has been kind enough to share with me a chart that he has developed that is useful in detecting a bubble in the housing market. His chart below shows the ratio of the average existing home sales price to average household income. The long term average (LTA) of this ratio has been slightly above 3.0. At the beginning of 2001, however, it began to rise rapidly, reaching a peak 33 percent higher than the LTA during 2005, and then declining precipitously back to its LTA during 2008.

Peshut’s chart also shows that, as of the beginning of 2012, Fed monetary policy had been unable to restart a bubble in the housing market unlike it had done in financial asset, farmland, and commodities markets. In fact housing prices were still falling both absolutely and in relation to household income. This is apparently beginning to change as it has recently been reported that the S&P/Case-Schiller Home Price Indices “showed that all three headline composites ended the year with strong gains. The national composite posted an increase of 7.3% for 2012. The 10- and 20-City Composites reported annual returns of 5.9% and 6.8% in 2012.” In contrast, national income rose by 4 percent and disposable personal income by about 2 percent year over year in 2012.

Average-Home-Price-To-Household-Income-Ratio-02-13-1

Joseph Salerno is academic vice president of the Mises Institute, professor of economics at Pace University, and editor of the Quarterly Journal of Austrian Economics. He has been interviewed in the Austrian Economics Newsletter and on Mises.org.

The Impact of Federal Reserve Policy on the Multi-family Sector

Editor’s Note: For its sixth post, RealForecasts.com is re-publishing a white paper titled “The Impact of Federal Reserve Policy on the Multi-family Sector”, which was written in March of 2010 and distributed by ING Clarion Partners to institutional investors and consultants.

Although the Fed stopped purchasing agency debt and MBS coincident with the end of QE1 in March of 2010,  it resumed its purchases with the commencement of QE2 in November of 2010 and continued purchases through the end of QE2 in June of 2011.  These continued purchases further bolstered multi-family lending and capital values and forestalled the risk of reversal in the multi-family property market that was raised by this paper.

The Fed’s third round of quantitative easing (QE3) began in September of 2012.  Unlike QE1 and QE2, QE3 does not have a defined timeframe and will reportedly continue until the employment market improves.  Combined with purchases of long-term Treasuries under “Operation Twist”, which is designed to drive down long-term interest rates, since September of 2012 the Fed has been buying $85 billion of assets per month.

The Impact of Federal Reserve Policy on the Multi-family Sector

Jeffrey J. Peshut, M. Gregory Chicota, David J. Lynn, PhD, Tim Wang, PhD, Bohdy Hedgcock

March, 2010

Executive Summary

We believe that the Federal Reserve’s explicit support for housing-related government-sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Home Loan Banks – has helped avert a more severe fall in housing values.  It has also helped to bolster multi-family lending and capital values.  This support appears to be waning, however, as the Fed has announced an end to the programs in March.  This policy shift will likely impact the availability and cost of debt for multi-family properties, which may have a spillover effect on property valuations.

Overview

In November of 2008, the Federal Reserve announced a $600 billion program to purchase the direct obligations of housing-related GSEs — Fannie Mae, Freddie Mac, and the Federal Home Loan Banks — and mortgage-backed securities (MBS) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. According to the Fed, the action was taken to reduce the cost and increase the availability of credit for the purchase of houses, which was expected to support housing markets and foster improved conditions in financial markets more generally.

Purchases of up to $100 billion in GSE direct obligations under the program were to be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions. Purchases of up to $500 billion in MBS were to be conducted by asset managers selected via a competitive process. Purchases of both direct obligations and MBS were expected to take place over several quarters.

Purchases of up to $100 billion in GSE direct obligations under the program were to be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions. Purchases of up to $500 billion in MBS were to be conducted by asset managers selected via a competitive process. Purchases of both direct obligations and MBS were expected to take place over several quarters.

In December of 2009, the Treasury Department quietly announced that instead of limiting its support to the GSEs to the previously-announced $600 billion, its support would be unlimited for the next three years.

Since the original program was announced in November of 2008, the Federal Reserve has actually purchased $152.4 billion of Federal agency debt securities and $970.3 billion of mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. The Fed said last month it will stop buying agency debt and MBS at the end of March. By then, the Fed plans to have bought about $175 billion worth of agency debt and $1.25 trillion worth of mortgage-backed securities.

GSE Share of Residential Mortgage Loans

The GSEs hold the largest share of single-family residential mortgages, including $5.1 trillion of loans that support the mortgage-backed securities they have issued and $446.4 billion of “whole” loans in their own portfolios. Combined, they account for approximately $5.5 trillion or 51% of the almost $10.9 trillion of single-family mortgage debt outstanding in the U.S. They are followed by Commercial Banks with $2.2 trillion (20%), Asset-Backed Securities issuers with $1.6 trillion (15%), Savings Institutions with $537.4 billion (4.9%), Finance Companies with $345.1 billion (3.2%) and Credit Unions with $318.4 billion (2.9%) (Figure 1).

The GSEs also hold the largest share of multi-family mortgage loans, with $197.4 billion of “whole” loans in their own portfolios and $162.2 billion of loans that support the mortgage-backed securities they have issued. Combined, they account for $359.6 billion or 39% of the $911.7 billion of multi-family residential mortgage debt outstanding. They are followed by Commercial Banks with $217 billion (24%), Asset-Backed Security issuers with $110 billion (12%), State and Local Governments with $66 billion (7%), Savings Institutions with $64 billion (7%) and Life Insurance Companies (6%) (Figure 2).

Impact of Federal Reserve Policy - Figure 1 and 2

It is worth noting that the amount of single-family residential mortgage debt outstanding greatly exceeds the amount of multi-family residential mortgage debt outstanding, with multi-family mortgages representing only 7.7% of all residential mortgage debt outstanding. More importantly for this analysis, GSE single-family residential mortgage debt outstanding dwarfs the amount of GSE multi-family residential mortgage debt outstanding, with GSE multi-family mortgages representing only 6.5% of all GSE residential mortgage debt outstanding.

Multi-Family Debt Outstanding, Interest Rates and Equity Returns

While the Fed’s program was designed to hold down home loan costs and stimulate the economy, research suggests that it has had the ancillary effect of increasing the availability and reducing the cost of credit for the purchase of multi-family residential properties. This in turn has slowed the rate of increase in the Income Return for NCREIF’s multi-family property sector — a proxy for capitalization rates (cap rates) — compared with NCREIF’s other property sectors.

From the end of the third quarter of 2008 through the end of the third quarter of 2009, a period which encompasses the Fed’s program, GSE multi-family residential mortgage debt outstanding increased by 9.5% (Figure 3).

Impact of Federal Reserve Policy - Figure 3

During the same four quarters, all multi-family residential mortgage debt outstanding increased by only 1% and commercial mortgage debt outstanding decreased by 1%.

As the outstanding GSE multi-family residential mortgage debt increased from the end of the third quarter of 2008 through the end of the fourth quarter of 2009, the cost of that debt decreased, with the interest rate on Freddie Mac’s 5-year fixed-rate loans declining by 90 bps, from 6.4% to 5.5% (Figure 4).

Impact of Federal Reserve Policy - Figure 4

From the end of the third quarter of 2008 through the end of the third quarter of 2009, the Income Return for the NCREIF Apartment Sector increased 88 bps from an historic low of 4.45% to 5.33% (Figure 5).

Impact of Federal Reserve Policy - Figure 5

This increase is less than the 116 bps increase in the combined Income Return for NCREIF’s Office, Retail and Industrial property sectors for the same period and would seem to reflect the impact of the increased availability and reduced cost of GSE debt on the Apartment sector.

Example From A Recent Transaction

A recent transaction highlights the impact of the increased availability and the lower cost of GSE debt for the multi-family sector. City Pointe is a five-story 183-unit apartment property that is well-located in downtown Fullerton, CA.

The property is subject to a $24,000,000 Freddie Mac floating rate loan that the seller recently put in place at a spread of 311 basis points over Freddie Mac’s Reference note, which is currently at 0.1%. This results in a highly-favorable current rate of 3.21%. The loan includes a 7% interest rate cap, a 5-year term, and can be paid off with a 1% penalty at anytime after November 2010.

Widely marketed by CBRE, the offering generated 50 property tours and 27 offers. About one-third of the offers exceeded $40 million. The bidders that submitted above $40 million included REITs, private buyers and exchange buyers. The property is expected to trade for approximately $42 million, which translates into an implied going-in cap rate of 5.25% on the nominal underwriting assumptions. On more realistic assumptions, we believe the expected purchase price will represent a going-in cap rate of approximately 4.9%.

Investment Implications

The analysis presented in this paper suggests that the Federal Reserve’s program to purchase the direct obligations of housing-related GSEs has increased the amount of GSE multi-family mortgage debt outstanding, lowered the interest rates on these mortgages and slowed the increase in income returns — and decrease in value — for multi-family properties. With the Fed’s recent announcement (January 2010) that it will stop buying agency debt and MBS at the end of March, it is reasonable to conclude that we may see a moderation in the positive effects on multi-family pricing. Combined with Federal Reserve Chairman Bernanke’s statement to the Financial Services Committee (February 13, 2010) about the Fed’s strategy for winding down the extraordinary lending and monetary policies that it implemented to combat the financial crisis, there is a greater risk that recent capital market trends for the multi-family property sector could reverse.

These considerations imply that current market conditions are providing a window of opportunity for multi-family residential owners to sell assets – whether to realize gains that have accrued to them over the past several years, pay down debt or increase liquidity. Surprisingly, the NCREIF Apartment Income Return is still only 88 bps above its all-time low.

Although the current economic and real estate market environment makes finding attractive multi-family investment opportunities difficult, prospective buyers should focus on properties characterized by strong and sustainable operating fundamentals – occupancy, rental rates, income and cash flow – that will offset the potential for cap rate decompression as the Fed’s support for the GSEs wanes.

Is There A Real Estate Bubble?

Editor’s Note: This is the second post for RealForecasts.com.  For its second post, RealForecasts.com is re-publishing a white paper titled “Is There a Real Estate Bubble?”, which was written in September of 2005.  Not only were there were bubbles in both the residential and commercial real estate capital markets, but the bursting of these bubbles that began in August of 2007 precipitated the greatest economic downturn in the U.S. since The Great Depression of the 1930s.

Is There a Real Estate Bubble?

By Jeffrey J. Peshut

September, 2005

The question on the minds of most real estate investors today is whether there is a “bubble” in the real estate capital markets and, if so, when will it “burst”.  I wrote the [previous post titled “Will Market’s Boom/Bust Cycle Repeat?”] in mid-1998.  The question then was whether there was a bubble in the stock markets and economy and, therefore, the real estate space markets.  Hindsight tells us that there was in fact a bubble in all three.  These bubbles burst about 18 months later.

Is There A Bubble?

Those who argue that there are bubbles in both the residential and commercial real estate capital markets today make the following case:

– We are once again nearing the end of a “credit-fueled” bubble similar to the credit-fueled bubbles that ended during the late 1980’s and late 1990’s.

– The Federal Reserve and commercial banks cause these bubbles by artificially expanding the supply of money and credit.  The Fed expands the supply of money and credit by buying Treasury Bills in the open market or by lowering the discount rate as a means of lowering short-term interest rates.  This expansion of the money base is magnified by the impact of fractional-reserve banking.

– When the Fed pumps money into the economy, interest rates drop — at least at first.

– As the commercial banks’ reserves increase and interest rates decrease, businesses take out bank loans to invest in projects that weren’t profitable at the higher interest rates previously set by the free market.  As businesses hire workers and buy equipment and raw materials to implement their investment plans, the economy picks up and the boom phase of the cycle begins.

– The boom, however, is founded upon an illusion.  The government appeared to enlarge the pool of savings available for businesses to invest, but in reality it created money that didn’t exist before.  It’s this money that was created “out of thin air” that creates the bubble.

– After all, the government can’t create wealth or real savings.  It can only confiscate and redistribute existing wealth through taxation or inflation.  When the Fed reduces interest rates by inflating the money supply, it in effect confiscates part of our wealth by inflation and lends our money to borrowers at the below-market rates referenced above.

– This subsidized interest rate sends a false signal to businesses, encouraging them to invest in projects that consumers weren’t in fact willing to pay for.

– Alas, all credit-fueled bubbles must end.  Otherwise, we risk hyper-inflation or a collapse in the value of the dollar relative to other currencies.

– To end the bubble, the Fed must reverse its earlier policy and contract the supply of money and credit.

– During the late 1980’s, concerns about the rate of inflation for goods and services and a weak dollar lead the Federal Reserve to drastically tighten credit and end the bubble.  During the late 1990’s, “irrational exuberance” in the stock market led the Fed to tighten credit and end that bubble.  Today, concerns about a “housing bubble” and a weak dollar seem to be the impetus behind the Fed’s increasingly tight monetary policy.

– When credit-fueled bubbles end, they burst.  And when they burst, the ill-advised investments that businesses made during the period of the Fed’s loose monetary policy are exposed.

According to this line of thinking, the question of whether the “bubble” in the real estate capital markets will “burst” becomes not “if” but “when”.  And once it does, by “how much” will values decline.

If So, When Will It Burst?

To attempt to answer the “when” question, I offer the following observations:

– During the last “credit-fueled” bubble, the rate of growth in the money supply reached its peak in mid-1998 and its trough in late-2000.  This correlates closely with the Fed’s “loose” monetary policy from early-1995 through early-1999 and its “tight” monetary stance from early-1999 through late-2000.  See the following [Fed Funds Rate and REAL Money Supply (RMS) graphs.  See also “The Mystery of the Money Supply Definition” by Frank Shostak (The Quarterly Journal of Austrian Economics Vol. 3, NO. 4 (Winter 2000): 69–76.)   REAL Money Supply represents the true definition of the money supply outlined in Dr. Shostak’s article.]

Fed Funds Rate 1975 - 2005

REAL Money Supply 1975-2005

– During what is arguably the most recent “credit-fueled” bubble, the rate of growth in the money supply reached a peak in early-2002 and again in early-2004, before beginning its current descent.  Again, this correlates closely with the Fed’s loose monetary policy from late-2000 through early-2004 and its tight monetary stance since early-2004.  It also correlates closely with the most recent run-up in prices in the residential and commercial real estate capital markets.

– Recently, [RMS has] been increasing at a decreasing rate.  “Real [RMS]” ([RMS] adjusted for price inflation) correlates closely with changes in Industrial Production – a key measure of economic activity — with a 12-month lag.  “Adjusted [RMS]” ([RMS] adjusted for price inflation and economic activity) correlates closely with changes in the stock markets, with a 4-month lag.

If past is prologue, the effect of the Fed’s current tight monetary stance on the money supply’s growth rate creates a significantly heightened risk of a slowdown in economic activity, a correction in the stock markets and a correction in the real estate capital markets in the year ahead.

How Much Will Values Decline?

With respect to the question of “how much” values will decline, the following observations are noteworthy:

– From 1995 through 2004, the spread between going-in cap rates and the 10-year Treasury averaged 320 bps.

– A year ago, going-in cap rates and 10-year unlevered IRR’s were 7.0% to 7.5% and 8.25% to 8.75%, respectively.  These going-in cap rates represented a spread of approximately 280 to 330 bps over the 10-year Treasury, consistent with the historical average.

– Today, going-in cap rates and 10-year unlevered IRR’s are 5.75% to 6.25% and 7.0% to 7.25%, respectively, for “core” real estate investments.  The going-in-cap rate represents a spread of approximately 155 to 205 bps to today’s 10-year Treasury.

– This spread is not only narrow for cap rates, but would also be narrow for commercial mortgage spreads.  From 1996 through year-to-date 2005, the spread between commercial mortgages and the 10-year Treasury averaged 190 bps.

– According to L.J. Melody, today’s rates for fixed-rate commercial mortgages are 4.9 % to 5.5% for the four major property types.  These rates represent a spread of 70 to 130 bps over the 10-year Treasury, approximately half the historical average.

– Therefore, it appears that last year’s cap rate levels were sustainable based upon historical averages but that the 125 bps decline in cap rates and IRR’s during 2005 will prove to be unsustainable.

– For a property with NOI of $5 million, a 125 bps increase in today’s going-in cap rates would result in a decline in value of 17% to 18%.  It is important to note that this decline in value reflects only a return of the going-in cap rate spread to its historical average.  It does not reflect a change in the 10-year Treasury rate.

– It is also important to note that a 17% to 18% decline in value requires a 20% to 22% increase in value to return to the value that existed before the decline.

One final observation: Once bubbles burst and market values decline, market values typically take a long time to recover.  For example, five years after the bubbles in the stock markets burst, the Dow Jones Industrial Average is still only 90% of the all-time high it set in early-2000.  Similarly, the S&P 500 Index and the NASDAQ Composite Index are only 80% and 45%, respectively, of their 2000 all-time highs.  Therefore, once the real estate bubble bursts, it could take several years before real estate values return to the levels they achieved at the height of the bubble.