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.