Thin-Air Credit Growth Slowdown Augurs Poorly for 2018 Domestic Demand Growth

A majority of my readers (two) have asked me to update the discussion about the behavior of thin-air credit or a variant thereof, namely the sum of commercial bank credit (loans and securities) and the monetary base (bank reserves at the Fed and currency). To paraphrase the motto of the former iconic Chicago department store, Marshall Field’s, give the customers what they want. To give the “customers” a preview of what they are going to get, let me state that thin-air credit growth has slowed to a rate that is low both from a long-run and short-run perspective. The slowing growth in nominal thin-air credit in conjunction with the acceleration in consumer price inflation has negative implications for growth in real U.S. aggregate domestic demand in 2018. In turn, if growth in real aggregate domestic demand “surprises” on the downside in 2018, then the Fed is unlikely to hike the federal funds rate the full 50 basis points this year that the market currently expects. Alternatively, if the Fed is hell-bent on raising the federal funds rate 50 basis points or more over the remainder of 2018, it would be sowing the seeds of a 2019 recession unless there is an acceleration in the growth of nominal and real thin-air credit. An acceleration in the growth of thin-air credit would be unlikely in the face of a rising federal funds rate.

As shown in Chart 1, year-over-year growth in thin-air credit has trended lower from its 9+ percent observations from Q4:2013 through Q3:2014. As of Q1:2018, year-over-year growth in thin-air credit was 2.7% -- low growth in terms both of a long-run and short-run historical perspectives.

Chart 1

Plotted in Chart 2 are the year-over-year percent changes in the quarterly observations of, again, thin-air credit (the sum of commercial bank credit and the monetary base) along with the percent changes in each of its major components – commercial bank credit and the monetary base – by themselves. The slowing growth in thin-air credit (the red line) in 2015 and 2016 was primarily due to the Fed’s cessation of quantitative easing (QE), i.e., large outright purchases of government securities and quasi-government mortgage-backed securities, which resulted in the year-over-year contractions in the monetary base (the green bars). Surprisingly, at least so to me, was the rebound in year-over-year growth in the monetary base in the past three quarters inasmuch as the Fed had started to reduce, albeit marginally, its outright holdings of securities and the Fed had been hiking the federal funds rate. Starting in 2017 and continuing through the first quarter of 2018, growth in commercial bank credit the blue line) has been trending lower, which has restrained the growth in thin-air credit.

Chart 2