Friday, February 11, 2011
The big news from the monetary front is that there is no news. M2, arguably the best measure of the money supply, is growing at the same pace as it has been for many years—about 6% per year on average. There is no sign of any unusual growth in the amount of money in the economy, despite the Fed's purchases of more than $1 trillion worth of securities (aka QE1 and QE2).
We do see the monetary base (currency plus bank reserves) growing recently, which is to be expected given the Fed's ongoing purchases of Treasuries, since they are paid for by creating bank reserves. But the extra base money is not translating into more money in the economy; the banks are just sitting on the extra reserves. This may be because the economy's demand for loans is not picking up, and/or because the banks are still reluctant to lend, preferring to accumulate reserves (a risk-free asset) instead of (risky) loans on their balance sheet.
This chart of excess reserves underscores the point: virtually all of the extra bank reserves the Fed has created in the past 2+ years are sitting idle at the Fed.
To simplify what has happened: the Fed has effectively swapped bank reserves for Treasury securities. This has reduced the amount of Treasury securities in the world and increased the amount of very short-term securities (bank reserves are similar as an asset class to T-bills; both are risk free and both pay 0.25% annual interest). The Fed has thus assumed a good deal of interest rate risk, because the price of its security holdings will decline if interest rates rise. At the same time the world has reduced its interest rate risk by a corresponding amount.
To date, this all looks like a deal struck voluntarily by consenting adults, with no apparent inflationary consequences (since a permanently and significantly higher price level would require a permanent and significantly greater amount of M2 money). However, this is very unlikely to be a long-term equilibrium situation. Banks could decide to deploy their reserves to expand their lending, which in turn could pump a lot of additional money into the system. Can the Fed reverse course in time to prevent a serious buildup of inflationary pressures? Bernanke says yes, but the proof will be in the pudding, as they say.
Meanwhile, the action in the FX, gold and commodities markets suggests that a lot of people are looking to get protection against a decline in the dollar's purchasing power, and that is a classic symptom of an inflationary problem in the making. The dollar has fallen against other currencies, and gold and commodity prices have risen, because the world is uncomfortable with the amount of dollar exposure it has. This is another way of saying that while the Fed's actions haven't resulted in any unusual expansion in the supply of money, the world's demand for dollar money has declined. Weak dollar demand can cause inflation just as easily as excess dollar supply, if the Fed does not take steps to soak up the unwanted dollars, or to increase the world's confidence in, and desire to hold dollars.
Much remains to be seen, and this potentially huge source of monetary uncertainty is still weighing on nearly all markets. Monetary uncertainty and fiscal excess (i.e., too much spending and the threat of higher tax burdens that this creates) are acting like significant headwinds to economic progress. It's a vicious circle, since the weak economy that results from all this uncertainty only encourages more of the same. We really need some convincing action from Congress to cut the size and burden of the government, and from the Fed to reverse its quantitative easing. The sooner the better.
Posted by Scott Grannis at 12:34 PM