The Federal Reserve’s Open Market Committee met this week and decided to let its most recent monetary easing program end as scheduled. Chairman Ben Bernanke also held a news conference where he took questions from reporters on Fed policy.
This was a first, although it continues a trend toward openness begun some 20 years ago. On the whole, both actions were good, although the jury may stay out for decades on the prudence of ending the latest monetary expansion program. (If it had decided the other way, the jury would also remain out.)
One intractable problem from the point of view of the public’s understanding of the Federal Reserve is that the variable over which the Fed actually has some control — the money supply — is difficult to understand. Thus, the media, and sometimes the Fed itself, describe policy changes in terms of their effects on a secondary variable, interest rates. This causes confusion.
The problem is even deeper because the Fed’s control over the money supply is not direct. All it can do with any precision is to change something called bank reserves. These are deposits in banks that are not loaned out or invested in bonds. Some reserves are required by law. Holding reserves beyond this is a management decision of the bank.
As long as the relationship between these bank reserves and the money supply — the sum of all paper money, coins and bank deposits in the economy — is fixed, or at least predictable, then Fed control over reserves is tantamount to control of the money supply. This ratio is quite predictable in normal times. Unfortunately, we have lived under extreme abnormality for nearly four years now and the end is not in sight.
The relationship between the two depends on how aggressively or diffidently banks loan out available funds. Since the panics of 2008, banks have been diffident in the extreme.
Add currency in circulation to the bank reserves just described and you get what economists call the monetary base. From August 2007, when the wheels began to come off the global financial sector, to now, this monetary base increased by a factor of 2.85. Put another way, this monetary base is 185 percent larger than it was 44 months ago. But the money supply itself has increased only 21 percent.
That was sufficient to drive short-term interest rates to near zero by late 2008. (Achieving that drop took only an 11.5 percent increase in the money supply, but the Fed nearly doubled the monetary base in getting there.)
Look at Fed policy from the point of view of interest rates, and there has been no change in 28 months.
Look at it in terms of what the Fed actually controls, however, and you see that it increased the monetary base by another 20 percent from the end of 2008 to September 2010.
Since then, in the quantitative easing effort that will peter out in June, this base has gone up yet another 22 percent.
Over all this time, the Fed did the only single thing in its power to do: increase bank reserves by buying up bonds and, especially in the panicked days of 2008, lending directly to banks. This in turn increased the monetary base, which increased the money supply and decreased interest rates. But these linkages are all highly variable, especially in times of uncertainty.
It is hard for the average reporter to understand this and even harder to explain to the average reader or viewer. So it is presented as completely separate actions: the Fed lowered interest rates, the Fed “bailed out” banks and the Fed bought bonds.
How increases in the monetary base and the money supply affect credit markets and the overall economy is also misunderstood. The Fed uses a very short-term interest rate as its announced target.
But an increase or a decrease in the money supply affects virtually all interest rates, though certainly not all equally.
When the Fed buys up mortgage-backed securities, as it did in 2009-10, a first effect is to reduce interest rates for mortgage loans. But rates on other lending are reduced as well. When the Fed buys up government bonds, as now, the first effect is on interest rates for that class of bonds. But again, the increased money supply affects rates on all loans to some degree.
A recent wire service story said that ending bond purchases could push up interest rates on such bonds and on “other loans pegged to the Treasury securities.”
No pegging is necessary for there to be an effect. Slower growth of the money supply affects all interest rates, although not equally.
Stock, bond and foreign exchange markets often react sharply to new Fed announcements.
This makes people think the results of Fed policy changes are immediate. But these immediate reactions are superficial. The full effects of changes in the growth of the money supply take a long time, often up to a year and a half, to have full effects on the economy, both in terms of fostering growth and of igniting inflation.
There still is great uncertainty. Inflation is a possible danger looking forward. But so was deflation and collapse of the financial system looking backward, and that risk is not completely dead.
Whether the Fed made the right choices so far is a debatable question, but one must understand that the dangers it faced on either side were real.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.