By Jeffrey J. Peshut

March 26, 2015

At its March 18^th 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

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 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

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

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

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.

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.

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

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.

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

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

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

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

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

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

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

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 also be 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/.