Where would you hide a trillion dollars?

A trillion dollars is a lot of money.  It is in fact more than actually exists in circulation.  And it is presently hiding from everyone in plain sight at the Federal Reserve.  

Regular Reserves of Depository Institutions have historically been the pots of money that banks have to show the Fed, to assure them they are still capable of staying open.  Think of a casino where you can't get in, until the guy sees that you have a few 20 spots in your pocket.  Little noticed, the Reserves numbers just sort of stayed there year in and year out and are very boring.

Excess Reserves are the money that banks put into the Fed when things get a little jumpy out there, above and beyond Regular.  Big moves in Excess Reserves are basically when the Fed turns into a panic room, and banks stuff it with their money.  When the all-clear is sounded they take it back again and go about their business.  Excess Reserves are Run-to-Daddy time.

For decades Excess Reserves have been rather steady, with the bumps generally coinciding with notable geo-political events or financial crises (click to enlarge):

Then of course in 2007 the real estate bubble began its overdue correction and all hell broke loose as it imploded.  Let's look at 2001-July 2009, to put the 9/11 'spike' into relative context with the advent of the financial crisis:

So what happened?  Well part of the bailout, er, stabilization, was the Federal Reserve announcing in October 2008 that they would start paying interest to banks on their excess reserves.  The concordant amount of money-equivalents that fled the system to the Fed safehouse jumped $200BN in that month, and by New Years stood at $767 billion.

That's a huge shift.  The amount of money that went into this category in just three months, exceeded the total amount of money we've spent on the war in Iraq since its beginning ($711 billion as of the time of this writing).  

Banks are now being paid by the Federal Reserve to park cash or junk assets counted the same-as-cash, whereas before they were not paid and would therefore lose money (since banks make money by lending it out).  

• "The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability."  - FRB Press Release, October 6, 2008. 

So, while banks were cutting the rates on your savings account to zero, they were getting paid by the Federal Reserve to open up their own savings accounts.  Pretty nifty, right?

Now perhaps the official story is true, and the fact that lending dropped off a cliff to credit-worthy businesses and others at the same time banks were getting paid was a sheer coincidence.  What does not appear to be in dispute is that the reduction in lending exacerbated the recession, likely further hurting employment and sending real estate another leg down.  Since reserves are needed by banks to actively make loans, I find the official story a little hard to believe.

But let's expand the view through present, to get a sense for how big this program has gotten since the stabilization rationale was presented.  

As of February 2010 there was $1.162 trillion dollars in Excess Reserves at the Federal Reserve, and its not slowing.

Interestingly the interest being paid to banks on these balances comes to just about $3 billion dollars annualized.  If the Fed was buying 5-year Treasuries at around 2.25% then the Fed is making the difference of about 2%, or $23 billion in profit.

What I think is most concerning though is that I believe the Fed is setting the stage for market distortion in the years to come in a way that could impact everyone from wage workers to retirees.  The Fed is taking these Excess Reserves and using them to buy other assets like US Treasuries.  This can create the appearance of  strong market support for the US dollar, since the mass purchases by the Fed of US Treasuries is helping keep those prices higher (and interest rates lower) than would be the case if free markets were to set the price.

Not unlike some of the recent Ticketmaster scandals... by those hackers who cracked the code and bought all the tickets for hot concerts before they went on sale to the public, who were then in turn forced to pay higher prices from re-sellers... if all this use of Excess Reserves is adding artifice to the US Dollar without fixing the underlying problems in US banking institutions (such as unregulated derivatives), then it could be the underpinnings of an even larger house of cards that market forces will eventually correct.  If the markets correct the imbalance in a sharp, uncontrollable way interest rates could skyrocket.

We also call this monetizing the debt, and it often leads to hyperinflation with rapidly rising prices (without necessarily any increase in pay for the people). 

So, monetization of sovereign debt is one of those really, really big no-no's.  It can lead to rather Weimer-esque replays that we should be re-studying now, because the use or abuse of Excess Reserves as a monetary tool could be affecting the Treasury prices in a way that looks pretty now, but is in fact masking structural defects in the trading schemes of Wall Street.

We ought not be afraid of creative destruction, capitalism needs a clear view to separate the winners from the losers.  We've spent a lot of time trying to prop up the losers in this business cycle.  I would have rather we conserved those resources for more important initiatives, such as renewable energy, investments in mass transportation, or public education.  It will telling to watch the ER figure to see what the Financial system and the Fed are doing with US capital flows, and to see how any distortions in the treasury market affects our ability to grow sustainably.

Peace out.

The Great Recession ended in July 2009 (give or take)

One might reasonably think the process for mapping the beginning and ending of recessions is a fairly transparent and straightforward process.  After all, the economic cycle is integral to the lives of most everyone I know (and to the remainder, I envy you) but the truth is that these calls come months, if not a year or more after the fact.

Just who makes these calls anyway?  Well despite our massive investments in the public sector and related data collection activities, there is in fact no one in the DC apparatus... no presidential appointee, no congressional committee, nay, not even an intern, charged with this rather important task. 

Most tune in to the reports issued by an entity called the National Bureau of Economic Research (NBER).  The NBER is a private, non-profit group that does quantitative and fundamental analyses on the economy out of the brain trust cities of Cambridge, Palo Alto and New York.  And it really is the only one that declares when recessions begin and end.  Typically these declarations come months (if not a year or more) after the fact. For our current Great Recession, they didn't identify the start date of December 2007 until November 27 2008!

This sort of strikes me like an ump who waffles on calling the pitch, when it's kinda sorta needed right there.  According to the Rulebook of the Economy however, the umps at the NBER have the option of heading home, and watching the replay from five different angles before making the call.  Meanwhile the rest of us hold our collective breath, hope our jobs don't go poof, and all the while policy makers waste time arguing whether or not there is a recession and what should (or should not) be done about it.

So what goes on inside the NBER?  Well as a card-carrying member of the Public I don't know either.  Now in reality I like the organization and I poke fun at them in jest, but seriously, in the age of Now the wait just seems damn slow.  I can't understand why it takes so long to "declare" a beginning of a recession or its end.

I have a superabundance of enthusiasm, a trait inversely proportional to patience.  In layman's terms this means that for me, spending three long years to see the entire Lord of the Rings trilogy practically drove me batshit.  Lesson learnt, I chose to wait and watch seasons 1-4 of "Lost" all in one Epic DVD blast.  I was much happier.

Now as a Quant, when I see gigabytes of data (in many cases floating free on those internets)  I want to wrestle with it, pound it, spank it, and above all make it give me answers.  The statistical methods are a means to enlightenment, a way for me to cut through the bullspin and identify where we are now and what conditions will likely prevail tomorrow. 

 And when I see a pattern emerge from columns of dummy variables I screech, buckle down and compute.

I spent some time poring over different public data sets in order to find a better real-time indicator of the economic cycle.   In the matter of recessionary starts and stops I discovered one that appears to be uniquely suited to the task, and I have been following it monthly since the first term of the second Bush.

I found the keystone within the Bureau of Labor Statistics, which among other series discloses US Non Farm Payroll data. Most media report the same data, which is monthly or weekly estimated changes but there is one iteration of the raw data which is routinely overlooked and must be computed manually.

1.  Take the raw data series (curiously, better delivery of BLS from the St. Louis Fed Reserve) and import to Excel. 

2.  Text-to-column the series

3.  Compute simple Year-over-Year percentages, subtracting integer '1' from the result.

4.  Overlay NBER Cycle Dates.

5.  Multi-line plot to get the following (click to enlarge).

This series covers monthly data for 70 years, from 1940 - Feb 2010.

The blue line shows the YOY change in Non Farm Payroll data (seasonally-adjusted, though NSA is comparable).

The vertical red lines are the NBER-declared beginning and end dates for officially-declared recessions in the United States.  The 0% YOY horizontal line is set about the middle of the chart, to better clarify the positive and negative deltas in relation to the recessionary periods.

Note that nearly every declared end to a recession (no matter when it was declared, often much later) occurs around an absolute trough bottom in the YOY series.  This doesn't mean the pain is over, but rather that the rate of job losses is slowing down instead of accelerating.  The economy grinds its way back towards the growth line (0% is the inflection) even though Main St is still shrinking, until it reaches positive growth again.

The precise beginnings of recessions are a little more nebulous using this method/series but generally coincide with:

• A steep declination in positive job YoY that reaches the ~0.75-1.30% zone, and
• Continues to fall through the 0% floor into negative territory.  

When these happen a recessionary period is generally declared.  The initial model I built using these momentum conditionals had pegged the start of our wonderful Great Recession as around Oct-Nov 2007, which is not far from the NBER-declared date of December 2007, a call they issued in November 2008.

Let's zoom in closer to the Naughty decade ('00+):

The telecom-dot com recession occupies a relatively short period at the beginning of the decade.  Our current recession is pegged as starting in December 2007 and no end has yet been declared.  However notice the trough was reached around July 2009 and job losses have been slowing on a YOY basis ever since.  If whatever methodology used by the NBER holds true for this cycle, then I believe this supports the notion that eventually they will declare the end of the current recession as being somewhere in the summer of 2009.

The reason I think this pattern holds through many different cycles (and they all had varying causes) is that non farm payroll data in absolute form is the best indicator of growth and contraction, period.  These data estimate how many people are actively collecting paychecks, and represent creative destruction cycles as one industry (or cheap money cycle, asset class, etc) rises, plateaus, fades and is replaced by other growing segments of the economy.  

This to me is an elegant series.

The purpose of this indicator is not to displace careful study that is needed on the business cycle.  Rather the idea is to provide early warning indicators to policy makers, bankers, business leaders and academia so that we can take actions to keep the economy growing in a sustainable way, and be aware well in advance of a severe decline so we can mitigate the impacts on ordinary Americans.  If the exact dates end up being revised a bit back and forth later, so be it!  Just as doctors help us monitor our health in a preventive sense, we can do better to monitor our overall economy and communicate these findings to the public in a sensible way.  

While many in our country were bearing the early brunt of the recession in 2008-2009, there were too many at the controls who were in denial that a contraction was underway.  Bond measures, social programs and war spending all amped up as if we were just taking a breather.  As we have seen, those assumptions proved baseless and ended up doing more harm in the long run.  

Forewarned, forearmed.