One of the main policy tools of the Federal Reserve Open Market Committee (FOMC) chaired by Janet Yellen is the Fed Funds overnight rate that banks charge each other to borrow Fed Funds.  The FOMC attempts to fix this rate by buying or selling Fed Funds in the open market.

There are Fed Funds futures markets which allow hedgers and speculators to buy or sell Fed Funds in the future.  At the Countdown to the Fed feature on the CME Group website, one can see the current probabilities for the Fed Funds rate at future dates.  From this page the following information can be gleaned.

• As of the 3/2/2017 market close the Fed Funds futures market is saying there is now a 75.3% probability that the FOMC will increase the Fed Funds target rate at their March 15th meeting - which is why interest rates in general have been rising in the past week.
  
• According to the Fed Funds Futures market, there is a greater than 60% probability that the Fed Funds rate will be .75% higher than currently and a > 25% chance that it will be 1.00% higher on January 31st, 2018.  3 hikes in 2017 is now market expectations.
  

This morning, the Department of Labor released the Initial Jobless Claims for the week ending December 4th.  Initial Claims rose 13k to 282k week over week.  The four week moving average increased by 1.5k to 270.5k. 

As can be seen above, the current level is barely above the recent lows - which are also below the lows reach in 1999 and 2005 for the past two expansions.  The 4 week moving average in jobless claims is down 8.2% from its level 52 weeks ago.

There is nothing in the Weekly Jobless Claims data that will stop Janet Yellen and the FOMC from raising rates next week.

Kevin Spires, CFA, FRM

The Federal Reserve just released their weekly balance sheet update (Fed H4.1 Report) and Monetary Base update (Fed H3 Report).  The Federal Reserve has held their balance sheet relatively constant just below 3 Trillion USD this year, with no growth in total over the past 12 months.

Over the past 3+ years, the composition of the Fed's balance sheet has changed, with most of the special programs rolling off and being replaced with Treasuries and Agency Mortgage Backed Securites (MBS).  At the height of the Crisis, special programs took up 1.5 Trillion of the Fed's Balance Sheet.

With the Federal Reserve not expanding their balance sheet, the supply of high powered money - the Monetary Base - has stagnated.  Over the past year, the Monetary Base has actually dropped by a bit over 1%.  This is not yet a worry, as most of the Fed Money Printing was just kept as excess reserves (which had reached 1.58 Trillion at their peak) on deposit with the Federal Reserve and not lent out.  The Monetary Base less the excess reserves   has grown at a healthy 9%+ rate over the past year.

While not yet a concern, because there are still 1.4 Trillion in excess reserves that banks could use to propel increased lending, these reports should be followed closely to see if banks are starting to lend out their reserves, or conversly, pull back from lending.

Kevin Spires, CFA, FRM

The Federal Reserve releases a break down of its Balance Sheet every Thursday afternoon.  The Fed has been holding its balance sheet fairly steady this year.  Changes in the Fed's Balance Sheet tend to hit the economy with a 12-18 month lag, so we are just now feeling the full effects of QE2 and Operation Twist won't be fully into the economy for another 6-12 months.

Monetary Base Growth Rolling Over?
The Monetary Base has been flat for the past couple of quarters - causing the year over year change to drop to 2%.  Does the Fed need to print more money?

Not really - over 50% of the Monetary Base is Excess Reserves held by banks at the Fed.  During QE1, there was only a 1% increase in the Monetary Base without Excess Reserves for every 10% increase in the Total Monetary Base.  After QE2 and Operation Twist, the relationship has been a 1% increase in the Monetary Base without excess reserves for every 2-2.5% increase in the overall Monetary Base.  In other words, Banks have been passing through a higher percentage of the Fed Money Printing as loans to Corporations and Consumers and the growth in the Monetary Base less Excess Reserves is still a healthy 10% year over year.  There are plenty of Excess Reserves for Banks to increase lending without any more increases in the Federal Reserves Balance Sheet.

Kevin Spires, CFA, FRM

The NY Fed has researched the ability of the slope of the Treasury Yield Curve to predict recessions.   I have reproduced one of their charts at the left which shows a 3.6% chance of the U.S. being in recession 12 months from now.

I have always liked the Yield Curve as a leading indicator because I think the slope of the curve is mostly driven by the relative tightness or easiness of the Fed's monetary policy.  Unfortunately, I believe most recessions are precipitated by the Fed's lurching from overly easy money to overly tight money.  Like a drunk continually falling off the wagon, easy money follows tight money as night follows day.


The main reason that I have blogged on this subject is not to take another gratuitous slap at the Fed (as fun as that may be), but rather to point out an improvement in the Fed's recession prediction toolkit.  In a March 2012 working paper posted on the main Federal Reserve website entitled "A Dynamic Factor Model of the Yield Curve as a Predictor of the Economy", the Fed has improved upon the NY Fed's simple yield curve model by coupling the trend growth rate of Industrial Production to the slope of the yield curve.  I simplify of course.  Don't click through unless you have a basic understanding of Markov Processes, Conditional Probabilities, and Maximum Likelyhood Estimation.

The key innovations are an improvement in the ratio of correct predictions (to 100%) and a decrease in the number of false positives (to zero) coupled with an increased average lead time at predicting peaks and troughs in economic activity of 22 months.  The end of the 2007-2009 recession was correctly predicted with a lead of 18 months.  In other words, this new model predicted an end to the 2007-2009 recession on 12/31/2007 - before most Economists had called a recession in the first place.  This is an astounding piece of research. 

We all learned in Econ 101 that Monetary Policy has a long and variable lag.  Now the Fed has quantified that lag at peaks and troughs - 22 months.  I am in the process of reverse engineering their model, but let me give you a hint - there hasn't yet been a call for the next recession.  If you have been paying attention to my blog posts, you would know that I am seeing an acceleration in activity that is normally associated with easy monetary policy and I am not surprised by the findings in this newish Fed Research. 

I imagine this paper has been circulated to all the high muckity mucks and grand poobahs at the Fed, so why do we continue to see a dovish contingent calling for more Quantitative Easing?  I think that the Fed Governors are, in general, no better than you or I would be at this Monetary Policy thingee.  Actually, I think the incentives in place make them substantially worse.  The Fed just "has to do something" or the whole reason for their being would be nullified.  They can't stand still and let nature take its course.  They over tighten and over ease to make the memory of their actions closer to the actual turn in the economy.  22 months is a long time to wait out the Economy and the vanity of Central Planning is such that the Fed must be seen to act in concert with the turn in the Economy.  Occam's Razor and all that says this is so - although I bet they wish it could be avoided in the case of recessions.

I think the Fed has, once again, stayed too easy for too long.  Sooner than most think, I expect the Fed to embark on a long tightening process that will lead us once again into recession - probably sometime 2015.

Kevin Spires, CFA, FRM

Industrial Production rose 1.1% in April after a downwardly revised -0.6% in March.  Capacity Utilization rose to a post-recession high of 79.2%.

The first thing to note is that the ISM New Orders Index is a good proxy for Q/Q changes in Industrial Production.  Current ISM New Orders of 58.2 are consistent with Industrial Production Growth of 1.5 - 2.0% Q/Q or 5-7% annualized.  Current data is moderately strong and does not show any signs of imminent collapse.

Given the growth rates in Industrial Production, Capacity Utilization has been growing as well.  With close to 5% growth rates in Industrial Production over the past 12 months, Capacity Utilization was up 2.67%.  Given the Expectations for Industrial Production to remain in the 5-7% growth range going forward, Capacity Utilization will probably grow by at least another 2-3% over the next 12 months.

The Key point to take away from this analysis is that Industrial Production and Capacity Utilization are growing at rates that will put Capacity Utilization in the range that is normally associated with normal to tight Fed Policy.  In this context, the current Zero Interest Rate Policy by the Federal Reserve is looking less and less tenable. 

The longer the Fed takes to normalize policy, the higher and faster that interest rates will ultimately have to rise to conteract rising inflation.  Call me a hawk on this one, but I am just judging the Fed against a policy reaction function, that in the past two interest rate cycles, caused two massive bubbles to arise - first the Internet Bubble and then the Housing Bubble. 

I wonder what Bubble will end up bursting this time around - because the Fed has fallen behind the curve once again.  I am pretty certain that a Bubble has been formed in the Social Networking sector of the Internet and I expect the current overly accomadative Fed Policy to cause massive dislocations in Credit, Currency, and Commodity markets going forward.  As the Fram Oil Filter commercial used to say "You can pay me now, or pay me later." 

Kevin Spires, CFA, FRM

The Federal Reserve releases an accounting of its Balance Sheet every Thursday.  The Fed's Balance Sheet has tripled in the past four years - although it has been stable for the past 12 months.  Most of the Fed's Balance Sheet is now Treasury Securities or Agency Guaranteed Securities (Both Mortgage Backed Securities ie.MBS and Straight Debentures).

It will be interesting to see if the Fed returns its Balance Sheet to the long term trend - which would require close to two trillion in Asset reductions.  I expect they will be cautious about announcing the removal of this stimulus - although it might happen sooner than most think.  Most think that the Asset Sales (or Asset run-offs as they decide not to reinvest proceeds) will start before they begin to raise the funds rate.

It should be interesting to say the least.  I think the Fed is waiting for more clarity on the Tax & Spending policies of the next Congress and President before clarifying how they will remove the massive amounts of monetary stimulus.

Kevin Spires, CFA, FRM

During its twice quarterly FOMC meetings, the Federal Reserve releases a statement that explains why it has the monetary policy that it does.  Quoting the FOMC statement, "In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions-including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014."  Now, most of the focus on low rates of resource utilization is on the Unemployment Rate which is currently above 8%.  In this post, I am going to focus on the other aspect of resource utilization - Capacity Utilization from the Federal Reserve's G17 Report.

Currently, Capacity Utilization stands at 78.6% for all industries and at 78.3% for Manufacturing.  Why is this so important?  Because, with the current rate of capacity take up, Capacity Utilization Rates will be greater than 80% by the end of 2012.

Historically, the Fed has started raising interest rates when the Capacity Utilization rate has been between 80-82%.  In February of 1994, Manufacturing Capacity Utilization was at 81.4% before the Fed first raised rates.  In early 1999, Capacity Utilization was barely 81 -82% when the Fed started the tightening that killed the Stock Market Bubble.  In 2004, Capacity Utilization was actually below 80 when the Fed started "normalizing interest rates."