Few things are more humbling for an economics professor than reading media stories about the economy. Somehow, a lot of people must get through our classes while missing the basics.
Nowhere is this more true than in reporting on monetary policy and the Federal Reserve. Econ professors evidently have failed to convey the simple idea that interest rates and the money supply are not independent of one another.
If you want to change interest rates, you have to change the money supply. That is the direction of causation. And, all other things being equal, you cannot change the money supply without therefore causing interest rates to change. Students learn that in their first course in macroeconomics.
Yet as the Fed has lowered its interest rate target for the Fed Funds rate on overnight loans between banks, one commonly reads statements like, “If lowering interest rates doesn’t help things, the Fed may have to increase the money supply.”
Over the past 14 months, the Federal Open Market Committee has progressively lowered this target from 5.25 percent to 1 percent. One now reads, “Well, the Fed cannot lower interest rates below zero, but it could increase the money supply.”
Well, of course it could. That is precisely what it has been doing for months on an unprecedented scale, although that has been largely unreported. The media instead focus only on the resulting interest-rate changes. Such coverage contrasts sharply with news reports during the last bad recession we experienced, in 1981-82. Margaret Thatcher had just become Britain’s Prime Minister by arguing one could end rampant inflation by slowing growth of the money supply.
At the same time, President Jimmy Carter had appointed Paul Volcker to chair the Federal Reserve Board. Volcker was a pragmatic monetarist, someone who focused on the crucial role of the money supply in the economy. Like Thatcher, Volcker knew that curbing money growth was the key to ending inflation.
He knew that curbing money growth would raise interest rates and that ending inflation would require punishingly high rates. But like Thatcher, he was prepared to do that.
All this has passed into the mists of memory. Now, in trying to end a financial crisis, the Fed is pumping enormous amounts of new reserves into the banking system. Normally that would increase the money supply, although it is doing so only moderately in the short term. But this is unreported in the media.
It is not because the data are not available. Every week, the Fed issues several statistical bulletins, including H.3 “Aggregate Reserves of Depository Institutions and the Monetary Base” and H.6 “Money Stock Measures.”
The monetary base consists of currency in circulation plus all bank reserves, that is, their deposits minus their loans. This is the variable the Fed controls through direct lending to banks or by open-market operations of buying and selling government bonds.
The Nov. 13 H.3 bulletin shows that the Fed increased this monetary base by 50 percent over the past 12 months, from $825 billion to $1.236 trillion. Such an increase is unprecedented in U.S. history.
The increase came through emergency Fed lending to sundry financial institutions. These went from $366 million in October 2007 to $15.4 billion one month later as the Fed went into panic mode. By early November 2008, such borrowing from the Fed reached $675 billion. This 44-fold increase in a year is extraordinary.
Over the past year, however, M2, the broad measure of the money supply, increased by only 7.4 percent, much less than the monetary base. What gives?
The answer is that the money supply depends not only on the monetary base, but also on how aggressively banks are lending. And while the Fed’s emergency interventions have ballooned the monetary base, banks have been contracting their lending sharply as part of the general deleveraging that is going on across the economy.
The crucial question is whether, when the economy eventually improves, the Fed can shrink this vast pool of its own lending without negative consequences. If it doesn’t, such an increase in the monetary base would be inflationary in the long run. But it is hard to retract credit at just the right time when an economy is recovering from the effects of a credit crunch.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.