Friday, April 8, 2011

Monetary policy update

Even as the evidence of rising inflation expectations mounts, it's important to not lose sight of the bigger monetary policy picture. The Fed has taken some extraordinary measures to ensure that the U.S. and world economies do not have to struggle with any shortage of liquidity. That involved the purchase of almost $1.5 trillion worth of MBS and Treasury notes. But the popular perception that they have expanded their balance sheet by printing massive amounts of new money (aka monetizing the deficit) is incorrect. Yes, they have created massive amounts of bank reserves, but almost all of those reserves are still sitting on the Fed's books—they have not been turned into newly printed money. The world probably has too many dollars, as suggested by the declining price of the dollar and the rising prices of gold and commodities, but the excess of dollars is not measured in trillions.

As I explained in a prior post, the Fed has not printed $1.5 trillion of new money—they have simply swapped $1.5 trillion of bank reserves for $1.5 trillion of notes and bonds. The bank reserves they have created are functionally equivalent to 3-mo. T-bills, and thus are viewed as among the very safest of asset classes on the planet. The Fed has apparently satisfied the world's demand for safe cash equivalents. By swapping reserves for notes and bonds, the Fed also has effectively shortened the maturity of outstanding Treasury debt. They haven't monetized the debt, they've shortened its maturity. That may well prove to be a very imprudent move from the government's perspective, especially if interest rates rise significantly, but it will shift a meaningful portion of the mark-to-market losses on notes and bonds in a rising interest rate environment away from the private sector and onto the Fed's books. Our government, and ultimately, taxpayers, are now more exposed to rising interest rates, whereas institutional investors are less exposed.

The charts that follow demonstrate that the only extraordinary result of the Fed's extraordinary actions has been an extraordinary increase in bank reserves. All other measures of the money supply are behaving within the range of historical experience. 


Bank reserves have increased by $1.4 trillion since September, 2008, when the Fed first began to implement its Quantitative Easing program. About $400 billion of that increase has occurred since QE2 began last November.



The Monetary Base (which consists of bank reserves and currency in circulation) has increased by about $1.6 trillion since quantitative easing started. $1.4 trillion of that increase represents bank reserves, and most of the remaining $200 billion consists of an increase in currency in circulation. As the second chart above shows, the growth of currency has not been exceptional at all when viewed in an historical perspective. In fact, currency growth was much faster during the 1980s and 90s, when inflation was generally falling. The most important fact to remember when it comes to currency is that the Fed only supplies currency to the world on demand. The Fed does not print up piles of currency and then dump them into the world. People only hold currency if they choose to hold it; excess currency can be easily converted into a bank account at any bank, and the Fed must absorb any unwanted currency at the end of the day, since banks are free to exchange unwanted (and non-interest-bearing) currency for interest-bearing reserves, and would be foolish not to.


The M2 measure of the money supply includes currency, checking accounts, retail money market funds, small time deposits, and savings deposits. As the chart above shows, M2 has been growing about 6% per year on average, after experiencing a "bulge" in late 2008 and early 2009 that was caused by an exceptional increase in the public's demand for liquidity. If banks had been turning their extra reserves into newly-printed money (which our fractional-reserve banking system allows), then M2 would be growing like topsy: $1 trillion of new bank reserves could theoretically support about $10 trillion of new M2 money, and nothing like that has happened.

So, at the end of the day, about all that has happened is that the Fed has exchanged about $1.4 trillion of bank reserves for an equal amount of notes and bonds. No new money has been created in the process, beyond that which would have been created in a normally growing economy with relatively low inflation.

That's not to say that banks will forever allow their reserves to sit at the Fed. In fact, banks appear to be stepping up their lending activities to small and medium-sized businesses, but these actions are still in the nature of baby steps. If the Fed fails to take action to withdraw unwanted reserves in a timely fashion, or to somehow convince banks to leave their reserves on deposit at the Fed, then we could have a real inflation problem on our hands. But that remains to be seen. The weak dollar and rising commodity and gold prices suggest we are in the early stages of a rise in the general price level that, in turn, would equate to a rise in inflation to, say, 5-6% per year. If banks begin to turn their reserves into new money in a big way, then we could potentially see inflation rise well into the double or even triple digits.

Allen Meltzer yesterday proposed one solution to this potential problem in yesterday's WSJ: "The Fed Should Consider a Bad Bank." He suggests that the Fed simply transfer all the extra reserves to a separate bank where they would be held until maturity, and thus unavailable to the banking system. I think it's also possible that the Fed could sell a significant portion of its reserves, by effectively reversing the swaps that created them in the first place. Would banks, and the financial system they serve, be willing to swap their risk-free reserves for notes and bonds? They might, especially if interest rates rise by enough, and if the world sees that the Fed has embarked on a viable exit strategy that will avoid totally undermining the value of the dollar.

The monetary policy picture is far from clear, and it is still potentially very disturbing. But it is not impossible or even catastrophic, not yet.

12 comments:

Andy said...

So here's a question worth pondering. With money market funds yielding near zero, quite a bit of money has gravitated to short-duration fixed income funds. If you add this back to your M2 calculation, I wonder if the numbers look significantly different...

Dr William J McKibbin said...

Scott, now you get it...

Scott Grannis said...

Andy: I don't have the numbers in front of me to do that, but I seriously doubt that it would make a significant difference.

Benjamin said...

I guess I am the black sheep here but I will bleat it out anyway. I bet every property owner in America would a like a slug of inflation to bring real estate values up.

Banks would benefit also from a lower foreclosure rate.

Exports would benefit from more exports.

Our national debt would be reduced (and I doubt we can pay it off otherwise).

Really, would some prosperity, inflation and boom times hurt that much?

dave said...

Scott,
Please feel free to correct me if I'm wrong but aren't bank reserves included in base money.

You seem to have a lot more confidence in Bernankes ability to finesse monetary policy than I do.

From what I see he doesn't include the early indicators of an inflation , gold oil and commodities in the his cpi index and as a result can't see inflation anywhere.

Charles said...

The main downside of shortening the maturity of government liabilities is to reduce the flexibilty of the government to respond to a global run on the dollar. They will be forced to move very, very quickly when and if the dollar collapses. That's because a debt consisting of T-bills must be refinanced several times a year.

As far as potential losses on the fed portfolio is concerned, these losses disappear when the fed is consolidated with treasury. Treasury is selling high interest bonds instead of low interest T-bills. The fed is buying high interest T-bonds and paying for them with low interest T-bill substitutes. Treasury's interest costs are high but this is offset by the fed's profits. Suppose interest rates rise. The fed loses money but Treasury is blessed with debt that has fallen in value. On a consolidated basis nothing is happening.

With respect to liquidity, one wonders if the fed has done anything at all other than bring $600 B in financial intermediation activity into the regulated banking system and out of the shadow banking system. This would only make a difference if the shadow banking system were in crisis (as it was in Fall 2008). If shadow banking can monetize AAA-rated MBS -as it did in the mid-00s - shadow banking can monetize T-bonds.

TradingStrategyLetter - Weekly Summary said...

As usual Scott you clear up issues that are on my mind. You actually make economic theory clear and interesting. Never thought that could be done!

Brian H said...

As usual, your post is amazing. Thank you Scott!

Benjamin said...

I keep hearing we will have real inflation and lower exchange rates for the dollar. I think we need both of these outcomes in moderation for several more years.

Each year I am disappointed as we have mild inflation to no inflation (even deflation), and the dollar merely inches down a bit.

Please, don't make such predictions unless you think they really will come true. It just gets my hopes up, and then dashed.

John said...

Good post, Scott, and somewhat reassuring.

The public perception is very different, that Bernanke is dumping piles of cash out into the streets. Where? I haven't seen any.

muhammad ali said...

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AdamSmith said...

Scott, thank you for taking the time to update this and set it out so clearly. It is a fine example of why your blog is a jewel. I'm not sure how useful it is to distinguish between bank reserves and currency as the reserves are only a very short step away from "money". I think our differing views perhaps stem from different premises. I am of the Rogoff/Reinhart and Boeckh school and believe that the Fed will engineer an "inflationary default" of the debt as the only way out and the bank reserves will provide the fire power to do it...