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Check this out: On April 6, 2011, Commercial Bank Reserve Balances with Federal Reserve Banks totaled $1.503 trillion (Federal Reserve Release H.4.1); for the two weeks ending April 6, 2011, Excess Reserves at depository institutions in the United States averaged $1.431 trillion (Federal Reserve Release H.3); and on March 30, 2011 Cash Assets held by Commercial Banks in the United States were $1.558 trillion (Federal Reserve Release H.8).

All these measures of excess cash in the commercial banking system seem to center around $1.5 trillion.

The Federal Reserve also reports that on March 30, 2011 the cash assets held by Foreign-Related (banking) Institutions in the United States totaled $702 billion or right at 45 percent of the cash assets held by commercial banks in the United States on that date!

The Federal Reserve policy of Quantitative Easing (QE2) is supposed to spur on bank lending which, hopefully, will contribute to a faster growing economy and lower unemployment.

The published figures indicate that a very large portion of the funds the Fed is injecting into the economy is going into the “carry trade” and contributing to the spread of American liquidity throughout the world.

One rationale that has been given for the policy that the Fed has been following is that when commercial banks aren’t lending (that is, there is a liquidity trap), the Federal Reserve needs to inject as much liquidity into the banking system as possible until the banks begin to lend again. This is the essence of quantitative easing.

This rationale was developed by people who studied the history of the Great Depression. Milton Friedman contended that a central bank should follow such a policy when faced with a banking system that was not expanding the money stock. Professor Ben Bernanke also suggested that such a policy be followed.

However, in the current environment, there are two things that seem to be different from that earlier period. The first relates to the international mobility of capital: in the period around the 1930s nations did not support the free flow of capital throughout the world because the international financial system was based on the gold standard and foreign exchange rates fixed in terms of the price of gold.

Thus, with international capital flows constrained, it was argued that a country could keep a fixed foreign-exchange rate for its currency and conduct its economic policy independently of other countries, thereby allowing the country to focus on reducing unemployment to more acceptable levels. The policy prescription advocated by Friedman…and Bernanke…could, therefore, be followed within such a world without major foreign repercussions.

This is not the situation that exists now. Capital flows freely throughout the world.

The second factor is that there was no designated national currency that was designated as the “reserve currency” of the world. Thus, currencies were seen as either fixed in value or were allowed to freely float in foreign exchange markets. (I am not dealing with “dirty” floats and so forth at this time because they are related to currencies that are not designated as “reserve” currencies.)

And, since the United States dollar serves as the reserve currency of the world and, because of this, is the default currency when there is a “flight to quality” in world financial markets, the value of the dollar does not fall to the level that is needed to allow the Federal Reserve to conduct its monetary policy independently of all other nations.

The consequence is that the Federal Reserve is inflating the whole world!

It is great for the currency of a country to be the reserve currency of the world. However, being the reserve currency of the world carries with it responsibilities.

One of these responsibilities is that the United States cannot conduct its monetary policy independently of everyone else!

The value of the United States dollar is higher than it would be if it were not the reserve currency of the world. As a consequence, the behavior of the value of the United States dollar does not act exactly as if it were determined if it were a freely floating currency in the foreign exchange markets.

Therefore, the monetary policy of the Federal Reserve, given the free-flow of capital throughout the world, cannot be conducted in isolation.

We are seeing the result of this situation right before our eyes.

The Federal Reserve is pumping money like crazy into the commercial banking system. And, 45 percent of the money is ending up in foreign-related financial institutions.

This, I believe, is not what the Federal Reserve wanted.

This, I believe, is not what the people of the United States wants.

And, I believe, that this is not really what the rest of the world wants.

Still, QE2 continues, unabated.

Source: Fed's Monetary Policy Cannot Be Conducted in Isolation