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Dr. Bernanke Love, or: How to Learn to Stop Worrying and Love the Fed – Part One of Three (or Four)

 

[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:

  • Open market operations, wherein the Fed buys securities from independent dealers, are the Fed’s most common method of money supply control.  Traditionally, these purchases have been limited to U.S. Treasury securities, but that’s recently changed rather dramatically.
     
  • Direct lending, including repurchase agreements, discount window lending, and other actions such as with AIG, where the Fed lends money to banks or other entities.

  • Currency swaps, wherein the Fed trades U.S. dollars (NYSEARCA:USD) to other central banks for foreign currencies, have been much more significant during this crisis than previously. 

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):

  • Currency Component of M1 is currency in circulation, not including currency held in depository institution vaults, at the Fed, or at the Treasury.  This is the narrowest definition of money, as it equates bank vault cash with bank reserves on deposit at the Fed, rather than with currency in people’s pockets.
     
  • Adjusted Monetary Base (NYSE:AMB) is the sum of currency in circulation, cash in bank vaults, bank deposits at the Fed, and an adjustment for changes in statutory reserve requirements so that the metric has meaning over time.
     
  • M1 includes most funds that are readily accessible, including currency as noted above, checkable deposits, and traveler's checks of nonbank issuers.

  • M2 includes all of M1 and other financial assets held principally by households including savings and money market accounts, small-denomination (<$100K) time deposits like CDs, and retail money market mutual funds.
     
  • MZM (money zero maturity) is M2 minus time deposits plus the M3 money market funds not included in M2.  This is the broadest measure of very liquid money.
     
  • M3, the broadest measure of the money supply, is M2 and large-denomination time deposits; institutional money market mutual funds; repurchase agreements issued by depository institutions; and dollar-denominated, U.S. non-bank deposits held at Canadian and U.K banks and foreign offices of U.S. banks.  The Fed stopped publishing data on M3 and some of its components in 2006 (a point of contention among those who believe inflation is under-reported); a bit more about M3 can be found here (http://www.federalreserve.gov/releases/h6/discm3.htm) and here (http://www.shadowstats.com/article/money-supply-revisited). 

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: 

Currency - 843; M1 - 1551; AMB - 1726; M2 - 8372; MZM - 9500; M3 - 14700

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.