Conventional wisdom is that the Fed’s printing presses are running overtime and the economy is awash with liquidity. Earlier this week the National Association for Business Economics reported that almost half the economists they surveyed believed that Federal Reserve Policy is inflationary. Too bad the NABE-surveyed economists and conventional wisdom are wrong.
Economists, pundits and journalists who climb the soap box to lecture Bernanke & Company about the evils of printing too much money need to take a second look at Federal Reserve policy.
If the Fed critics were correct, then overly aggressive monetary policy would be increasing the amount of money supply and hyper-inflation would be right around the corner. But, inflation is in check and if the Fed keeps on its current monetary trajectory high inflation isn’t in the cards for the U.S.
As it turns out, every week the Federal Reserve publishes statistics on money supply and since December 15, 2008, money supply has increased only marginally. M1 and M2 are up by about 4% and 2.5%, respectively. Such small increases hardly signal an out of control Federal Reserve led by “helicopter Ben” dropping money on the economy.
Fed watchers are correct, however, since the Lehman collapse the size of the Federal Reserve’s balance sheet has more than doubled. However, this growth of Fed size isn’t a warning of impending monetary or economic Armageddon.
While in the last year the size of the Federal Reserve’s balance sheet has grown from a little less than $1 trillion to around $2 trillion, what the Fed detractors neglect to mention is that the Federal Reserve didn’t print money to pay for the purchase of its new assets but rather sucked money out of the banking system that was being hoarded by banks, corporations and individuals. As a result, there was only a tiny net increase in money supply from Federal Reserve intervention. And, with only a small increase in money supply, inflation fears are being blown out of proportion.
Instead of printing “new money” and increasing money supply, Bernanke got banks to deposit their “old money” with the Federal Reserve, which meant that money supply didn’t increase. The Federal Reserve used that old money on deposit to purchase its new assets and grow its balance sheet.
Bernanke encouraged banks to deposit their excess funds at the Federal Reserve by persuading Congress to pass a law that allows the Federal Reserve to pay interest on cash deposits at the Federal Reserve. Prior to the change in law, the Federal Reserve couldn’t pay interest on money deposited, and as a result banks didn’t leave their excess funds at the Federal Reserve Bank. This very technical change in Federal Reserve authority provided Bernanke the magic wand to pull the banking system out of its death spiral without sparking hyper-inflation or running the printing presses overtime. Excess reserves on deposit at the Fed (which are essentially deposits of excess cash by banks at the various Federal Reserve banks around the country) total approximately $800 million and by sucking up excess reserves the Federal Reserve financed about 80% of its policy initiatives.
By recycling existing excess cash, the Federal Reserve stopped the negative effects of cash hoarding and pulled the U.S. out of a full scale depression. Bank cash hoarding at the end of 2008 depressed the velocity of money (i.e., the number of times it turns over each year) which almost caused an economic calamity for the U.S.
In a simple closed economy, annual GDP must equal (a) the amount of money multiplied by (b) the number of times money turns over in a year. If the velocity of money slows down, i.e., the number of times it turns over goes down, then GDP must fall. When the economy was in big trouble, in late 2008, banks, consumers and businesses were hoarding cash, which meant money wasn’t turning over. As a result, velocity dropped like a stone and GDP began to crash.
Bernanke and his staff were brilliant when they figured out how to stabilize GDP by forcing the velocity of money to stabilize and start to rise. Since Bernanke & Co. couldn’t rely upon the banks to recycle excess cash, they used their new authority to vacuum up the hoarded money and had the Federal Reserve Bank assume the role of private banks as an intermediary for money.
Prior to the beginning of 2009, the only successful policy that stabilized velocity of money and stopped panic hoarding was large-scale deficit spending by the central government which ultimately results in wealth redistribution and other social problems. Bernanke didn’t accept the standard prescription of aggressive fiscal intervention and instead invented as new paradigm of monetary policy.
As Bernanke’s policies started to work and panic hoarding lessened, the Federal Reserve began quietly reversing course and pulled back from some of its most aggressive measures. Pundits who question whether or not the Fed has the courage to reverse course and pull out monetary stimulus as the economy recovers need to look at actual data. They will see that there is no shortage of courage at the Fed.
Quietly and without fanfare, the Fed has gotten out of the business of being the lender of last resort for most of the securities market and broker dealers. As of the date of the last Fed report, the Fed had essentially $0 outstanding in its primary dealer, securities repurchase and commercial paper purchase facilities. And, the overall size of the Fed’s balance sheet was down between $100 million and $200 million from its peak level. Even the amount of credit that the Fed is providing to AIG is lower than it was at the height of the crisis. Plus, last week Fed governors started discussing whether or not all of the open market purchases of mortgage that have been authorized will in fact take place.
Every two weeks the Federal Reserve publishes a report that details the composition of its assets and liabilities. It should be required reading for pundits, economists and journalists before they talk or write anything about the Federal Reserve, Bernanke or his staff.
While I don’t agree with everything that Bernanke has done (particularly in the area of regulation), Bernanke and his staff are perhaps the most skilled monetary economists ever.