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The Fed Has Not Been Printing Boatloads of Money
By Bob McTeer Filed under Economy on March 21, 2013

Who is Bob McTeer?

Bob McTeer is a Distinguished Fellow at the National Center for Policy Analysis (NCPA), covering macroeconomic issues, including monetary and fiscal policy.

Bob is best known for his 36-year career with the Federal Reserve System, including 14 years as President of the Federal Reserve Bank of Dallas and member of the Federal Open Market Committee (FOMC).

So you would think that this chap knows of what he speaks…

As I listen to commentary on cable TV about the Fed’s quantitative easing, I find it amazing that people smarter than I, as well as better trained and more knowledgeable about many things, keep making the same mistake they have made for the past three or four years. Their predictions of an inflationary break-out and/or a collapse of the dollar haven’t come true during this time, but instead of going back and reviewing their assumptions, they merely say it is bound to happen even though it hasn’t happened yet.

His first argument is empirical in nature. The last 4 years have not seen an inflationary break-out, therefore, those who predict an inflationary break-out need to re-examine their premises.

fredgraph

The inflation rate is approximately 2.85% compounded in the time under question from Federal Reserve data. CPI data includes a 25% weighting from housing. Therefore the CPI data will significantly understate the inflationary pressures due to the significant fall in housing over this same period.

The next graph displays the M2 money series.

fredgraph (1)

The money supply has grown at an 8.15% compounded rate. The creation of money and credit is having less of an effect currently than it has in times past, which is commonly referred to as Keynes’ “money multiplier”, thus the lower inflation figures.

Why is that?

M2V_Max_630_378

With any given income there are three possibilities: [i] consumption [ii] investment [iii] hold as cash. The option of holding as cash is very high on the ordinal scale of marginal utilities currently. This accounts for the low inflation relative to the higher money & credit creation by the Federal Reserve.

What they fail to grasp is that their initial assumption that the Fed is printing boatloads of money simply isn’t true.

The evidence from the Federal Reserve data suggests that it is true.

If it were true, I would join them in their dire predictions.

Really?

But it simply isn’t true and hasn’t been true throughout this period. The latest estimates from the Fed’s H.6 Money Stock Measures show M2 growth actually declining since the Fed resumed significant asset purchases last fall.

That is true. Look at the data in the graph. While the statement is true, it is also taken so far out of context as to perpetuate a serious distortion of the truth.

M2 growth in the three months ending in February was 4.6 percent; it was 6.5 percent in the previous six months and 6.8 percent over the previous 12 months. Even this moderate growth is muted by the average decline in M2 velocity of around 3 ½ percent in recent years, yielding a growth rate of nominal GDP of roughly 4 percent per year.

Which I have already covered. The question now becomes, how, with that admission can you maintain your assertion that the Federal Reserve has not been creating new money and credit under the various QE programs?

Asset purchases by the Fed normally lead to a multiple expansion of money since, at the margin, reserve requirements are only about 10 percent of deposits.

This rather innocuous sentence hides the big lie. “Reserves” are the factor that can allow or prohibit fractional reserve lending, the primary source of money/credit expansion in an economy.

100% reserves means no expansion of money/credit via fractional reserve lending. 10% reserves means a multiple of 10 applies. Thus asset purchases by the Fed would under the rules of math see a 10X expansion of the money supply. It hasn’t happened because the rules of math do not necessarily apply to economic phenomena.

The commercial banking system was first bailed out with cash infusions, later, they swapped out of impaired assets [MBS] into Treasury paper. This Treasury paper can be exchanged for cash, if required, by selling it. The Federal Reserve is currently the largest purchaser of Treasury paper. The banks then have cash.

The roughly $2 trillion of asset growth from before the financial crisis through QE2 was largely offset, however, by an expansion in excess bank reserves of $1.6 trillion.

Bank reserves can be 1/10 of the expansion of the money/credit supply. Excess bank reserves are those reserves in excess of the 10% reserve requirement. Therefore $1.6 Trillion of excess bank reserves are an indication of low loan demand, or low loan supply. Either way they indicate a stagnant economy.

In other words, the banking system has been sterilizing or neutralizing the impact of the asset purchases on the money supply.

True.

The good news is this is why we haven’t had an expansion of inflation or a collapse of the dollar.

True. M2 Velocity data visualises the effect.

The bad news is that is also why the purchases have not stimulated economic activity more than they have. The effect seems to be limited to the downward pressure placed on interest rates.

Correct.

The Fed’s asset purchases have been increasing bank reserves. The Fed adds Treasuries and Agency MBS’s to its assets and pays, in effect, by crediting the reserve accounts of the banking system. But that’s where it has been stopping.

Incorrect.

For the Federal Reserve to be able to purchase assets they have to have “money” with which to do so. Money can be created electronically through creating credits/debits at the Federal Reserve, thus expanding the money supply at the push of a button. If the physical cash is required, it can be printed by the Treasury. Treasury debt is monetised in this manner. The Treasury creates a debt instrument, sells it to the Federal Reserve who create a credit that can be drawn down upon.

It is true that the Monetary Base, which used to be considered high-powered money because it consists of currency outstanding plus the reserves of the banking system, expands with the expansion of bank reserves.

So the money supply is expanding.

But, with banks hoarding excess reserves as they have been, the Monetary Base has not had its historical impact on the public’s money supply.

To date.

If one insists on calling the Monetary Base ‘money,’ then it is money that has gone only to the Treasury and the sellers of MBS’s.

Which is the commercial banking system.

This has made the financing of our outsized deficit easier and cheaper. That will come to an end some time and financing the deficit will become more expensive;

While interest rates across the yield curve are at all time historic lows.

then holders of fixed-income securities will experience market losses if they sell them before maturity. But there are no inflationary pressures building.

If not, then why would interest rates ever rise again? Interest rates will rise when inflation threatens to break-out of the comfort zone of the Central Bankers, which is probably just before the general population revolt to overthrow the government.