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Dr. Bernanke Love, or: How to Learn to Stop Worrying and Love the Fed – Part One of Three (or Four) 20 comments
[If this article looks familiar to you, there's a good reason. It was previously posted on Seeking Alpha under the wrong user account.]
We are not destined for massive inflation.
I know, I know, I’m a heretic and will be excoriated, belittled, crucified, and otherwise slapped around for taking such a stance. Fair enough. But facts are stubborn things. And the facts simply don’t indicate that inflation is a foregone conclusion.
It’s quite easy to believe otherwise, based on what appears in the media, including Seeking Alpha, on a near-daily basis. The Federal Reserve’s printing money like mad, the story goes, and such massive increases in the money supply must cause the value of the currency to fall. It’s simple supply and demand, they say; the more dollars relative to other things, the less those dollars are worth.
Which is all well and good, during normal times. But these are not them.
To really understand the prospects for future inflation, you have to look deeper into what’s happening with the Fed’s balance sheet and various components of the money supply. To do that, we need some basic definitions. This article is a primer, providing some basic information about the money supply and money creation. Part Two will dig into two more esoteric factors, money multipliers and velocity. In Part Three I’ll discuss developments in the monetary system in the last 18 months and explain why significant inflation is far from a done deal, and why suggestions of pending hyperinflation should be viewed as skeptically as roadmaps to Atlantis.
Where Does Money Come From?
This most basic concept is widely misunderstood and misrepresented, and without this knowledge intelligent discussion of the money supply is impossible. Money is created by both the public sector (by the Fed) and the private sector (by banks).
The Fed Creates Money
The Fed creates money by printing or minting it, or by crediting banks’ accounts at the Fed. Looking a bit deeper, the Fed has several mechanisms it can use to effect this money creation, including:
A Note About Interest Rates
When the Fed announces a change in the federal funds rate, it doesn’t just happen. The announced number is a target, and the Fed then takes action to expand or contract the money supply to the point that the market-clearing rate is at or near the target. Typically such changes affect rates all along the yield curve, but not always -- as illustrated by the persistence of low mortgage rates despite increasing federal funds rates in the mid-2000s.
Banks Creates Money
In the private sector, money is created through bank lending. Understanding the basics of fractional reserve banking and the money multiplier is crucial to understanding the money supply and money creation.
The government sets a reserve requirement, which is the fraction of demand deposits that a bank must keep in reserve either in vault cash or on deposit at the Fed, ready for depositors to withdraw (hence the term fractional reserve banking). With a reserve requirement of 10% (which is typical), suppose a depositor opens a $1,000 checking account at Bank A. The bank must keep $100 on reserve, and may lend the remaining $900; let’s say it makes a loan to a car buyer. This $900, which didn’t exist before the bank issued the loan, is used to buy a car, and is then deposited by the car dealer at Bank B. Of the $900 Bank B deposit, 10% must be kept on deposit, and $810 may be lent.
The more times this cycle repeats, the greater the amount of money created by the banking system. The limit, as the number of cycles approaches infinity, is called the money multiplier, and is the inverse of the reserve requirement (1/10% or 10x in this example). The Fed has a primer here: http://www.federalreserveeducation.org/fed101_html/policy/money_print.htm.
Note – there is at least one series of videos on youtube which gets this completely wrong. As I recall, the error lies in the notion that the money banks create is different from the money the Fed creates, that there are in effect two different classes of currency. This is simply untrue.
About Money, Deposits, Credit, and Debt
Strictly speaking, money and debt are two different things, but in the banking system they are two sides of the same coin. Basically, the amount of money created by a bank is equivalent to the amount of lending it does. From the $1000 deposit in the example, Bank A creates $900 when it lends that money.
A key difference is that while banks and non-banks can issue credit and take on debt, only banks (and bank-like entities such as credit unions) can take deposits, and only through leveraging deposits does private money creation occur.
To show the difference, suppose Pulte Homes finances a mortgage. An unsold house in its list of assets is replaced on the balance sheet by a mortgage, no money changes hands, no money is deposited in any bank account, and no money is created. By contrast, if a bank makes the same loan, the loan replaces cash on the bank’s balance sheet, the cash is paid to the builder, the builder deposits the money in a bank, and the money-creating cycle continues.
There are important money supply implications of the growth of non-bank issued debt, which I'll discuss in Part Three.
The Relationships Between Various Monetary Measures
There are several metrics related to the money supply, with the M’s (M1, M2, and M3) being the most widely recognized. Quick summary of some of the most important metrics (definitions from several Federal Reserve sources):
The Fed and the M’s
The Fed’s direct money-creating actions are completely measured by the AMB. Open market operations and Fed lending impact bank reserves on deposit at the Fed, which may be exchanged by banks for physical currency. Foreign currency swaps move dollars to overseas central banks in similar ways.
This is not to say that the Fed has no other options; the government could reduce the reserve requirement. Lowering the reserve requirement could be a very powerful money creation mechanism; reducing it from 10% to 9% would enable banks to create 11% more money. But there’s a cost, as banks would then be taking on more leverage and risk.
While the Fed's regulatory reach does include some non-M1 components of M2 (e.g., savings deposits, money market accounts, and CDs), such regulations don’t create money, but rather affect the banks’ ability to do so.
The M’s and Bank-Created Money
The banking system’s money creation powers are limited almost inversely to those of the Fed. Banks can’t create currency, but they do create required reserves, checkable deposits, savings deposits, CDs, money markets, repurchase agreements, and every other element of M2, MZM, and M3. The money creation of the banking system dwarfs that of the Fed. The latest money supply metrics, in billions and seasonally adjusted:
Various Money Supply Metrics, in billions, seasonally adjusted
(all data from http://research.stlouisfed.org/fred2/, except as noted)
The total money supply as described in M3 is on the order of 10 times the money created by the Fed.
Coming in Part Two: money multipliers and velocity – what they mean and what they don’t mean.
And in Part Three (and maybe Four): what’s happened in the last 18 months, and why it’s different from what happened in the previous 5, 10, or 20 years. And most importantly, what may happen next, and why future inflation is not guaranteed.
Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.
This post has 20 comments:
www.forbes.com/feeds/a...
"WRAPUP 1-US policy-makers say plan now to avert inflation
By Ros Krasny
TULSA, Oklahoma, April 9 (Reuters) - The United States economy will skid more deeply into recession in coming months, Federal Reserve policy-makers warned on Thursday, but it is time to start planning how to wind down spending to avert an inflationary surge."
Sadly for you, and for the Fed, the Chinese aren't buying it:
moneynews.newsmax.com/...
"Top Chinese Banker: Dollar Soon Irrelevant
Thursday, April 9, 2009 8:53 AM
By: Dan Weil
Zhu Min, executive vice president of the Bank of China, a government-run commercial bank, says that the Federal Reserve’s decision to print billions and billions in new dollars to head off the financial crisis would make the greenback irrelevant to global finance and trade."
You can silence much of my criticism by including in your coming article a convincing case that we will witness the emergence of the necessary political will that is required to reign in an inflationary recovery when / if one begins. Also please explain how current debt levels, which have been plainly revealed as intolerable, will be rendered tolerable without a wage/price spiral. Include in this explanation how loans which should never have been made will be honored. Mostly, though, tell me which Congressional democrat / fiscal conservative will lead the charge to reign in inflation by slowing federal spending and with it the economy? Will it be Frank, Pelosi, Dodd, or Obama his-most-exalted self? In the middle of which 2-year Congressional election cycle will this new-found determination to do the right thing show itself? Or will it be in the middle of a 4 year presidential campaign which coincides with the 2 year cycle? Volcker's presence on Obama's economic advisory board no longer fools anyone, least of all Volcker. The Fed knows that everyone can see the coming destruction of the USD by printing, and the jawboning is building to fever pitch.
"Money is created by both the *public* sector (by the Fed)"
invalidates all the rest.
In which sense the Fed is "public"?
Looking forward to part 2. This is a viewpoint which I haven't seen elsewhere.
Thanks, and I'll look forward to part 2.
I have always thought the best approach to markets is the Ross Perot outlook. Keep it simple for a simple Texan. There is no way that Big Macs increase in price for the next year or I won't be able to buy any. Myself and all my friends have either been laid off or had their wages frozen. So how we get inflation from that I don't know.
But I am interested in how this all works. Nobody has really explained how the "Fed Printing" actually causes inflation. I just keep hearing it over and over. But how! I am skeptical. If the fed could always cause inflation, it would be running at 20% already since they never stopped printing since 1998. But now the dollar is stronger and inflation has stopped - what gives.
Increasing the quantity of anything lowers its price. In the case of money, increasing the quantity of money lowers its value. Think of it in simple terms: say there are 1,000 dollars, and 1,000 bananas, and the price of bananas is $1.00. Now print 1,000 more dollars. If you are a banana vendor, once you learn that the money supply has increased merely by printing, at the whim of one man, most intelligent people will want more dollars for their bananas. Note also the "real" quality of bananas; you can't merely print them. So why exchange something real for something that can be clicked into existence on some central banker's computer, especially when you know he's clicking away like a madman?
Now imagine the above case where the money printers print not 1,000 more but 3,000 more dollars. This is what the Fed has done since September. Now imagine what the Fed's policies will eventually do to the value of the paper money. Now think about how smart it is in such an environment to "save" money, when the very people who print the money are trying desperately to lower its value.
By accepting paper with ink printed on it in exchange for something real, you trust that the people printing the paper money won't do so in excess. But you would be trusting the wrong people.
The radical dollar bulls here will confuse you by conflating "money" and "credit". To avoid this confusion you must learn more about fractional reserve banking.
Is that simple enough for a Texan?
Too close for comfort up there in DC?
On Apr 16 03:43 AM Homer II wrote:
> It's not "why is the article removed" but exactly WHO removed it?
> Or who exerted pressure on SA to do so?
> Too close for comfort up there in DC?
How much QE does it take to get us back to Happyland?
> BTW while on the road to perdition, this year's Soc. Sec payouts
> will exceed payroll deductions or so I've seen.
Not true. Social Security is expecting to have costs of $695 billion this FY against revenue of more than $800 billion. The last time revenue was less than $700 was FY 2005.
www.whitehouse.gov/omb...
www.socialsecurity.gov.../
> Do you know if those projected revenues include the the tax break
> and projected increases in unemployment?
There is no tax break in FICA, and my $800 billion understates the 2/08 estimate by about 6%.
> Sadly for you, and for the Fed, the Chinese aren't buying it:
I don't feel sad. I also tend to take anything said by Chinese bureaucrats with a grain of salt. And to top it off, I'm not nearly as concerned as those who believe that China's ownership of less than 7% of U.S. debt somehow put it in a position of power relative to U.S. economic policy.
> You can silence much of my criticism by including in your coming
> article a convincing case that we will witness the emergence of the
> necessary political will that is required to reign in an inflationary
> recovery when / if one begins.
Why do you think this is necessary, and why do you think it's missing?
> Also please explain how current debt
> levels, which have been plainly revealed as intolerable,
Intolerable to whom?
> will be rendered tolerable without a wage/price spiral.
U.S. debt was considerably higher relative to GDP at the end of WWII than it is now. No wage/price spiral ensued.
> Include in this
> explanation how loans which should never have been made will be honored.
The same way as loans that should have been made. Be more specific if you'd like a more thoughtful answer.
> Mostly, though, tell me which Congressional democrat / fiscal conservative
> will lead the charge to reign in inflation by slowing federal spending
The two are not closely related at all. Inflation is predominantly a monetary phenomenon.
> The Fed knows that everyone can see the coming destruction
> of the USD by printing, and the jawboning is building to fever pitch.
If "everyone can see the coming destruction of the USD," why is this not reflected in yield curves?
On Apr 22 03:07 PM Vox Rationalis wrote:
> SW Richmond wrote:
With a slapstick, maybe. J/K, great article, look forward to part II.
Do you know if those projected revenues include the the tax break and projected increases in unemployment?
BTW while on the road to perdition, this year's Soc. Sec payouts will exceed payroll deductions or so I've seen.
Deleveraging has caused it to dissipate quickly because of Mark to Market. Some of the Leverage has hard assets as collateral. Revising MtoM, will allow the Banks the time to do what the Government was going to do...hold it indefinitely.
Without Velocity, the increased money supply may as well be compost. A lot of money chasing a few goods. The consumer isn't about to chase anything soon. The Government won't begin its tunover until 2010.
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