Monday, June 15, 2009

Getting Carried Away with Monetary Base Growth

Think Markets guest blogger Jerry O'Driscoll, a former Dallas Fed VP, has sure gotten excited about Arthur Laffer's mention in WSJ about the explosion in monetary base. O'Driscoll writes:

Since September, 2008 the Fed has been engaged in policy of unprecedented monetary expansion. Arthur Laffer provides the numbers in The Wall Street Journal for June 11, 2009. “The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10.” ...The Fed promises it will withdraw all this liquidity when the economy begins to recover. If it does so, it must contract by a factor of 10. A great inflation, a great depression, or both are in the making.
There are two problems with O'Driscoll's comment. First, it is dangerous to focus on monetary base, rather than actual money supply, e.g., M2. The monetary base is not money out circulating in an economy, M2 is. M2 will impact the economy directly, the monetary base won't. During an economic downturn, the demand for cash is much greater and thus the monetary base does not result in as much money growth.

By O'Driscoll's focus on the monetary base instead of M2 gets him snared in the trap set up by the devious Paul Krugman.

The second problem with O'Driscoll's comment is more of a technical point at this time, but could develop into an incorrect reading of Fed policy. O'Driscoll states:

The Fed promises it will withdraw all this liquidity when the economy begins to recover.
Remember, O'Driscoll is referring to the monetary base. But the Fed, most recently said it is not going to withdraw the reserves from the system. It is going to control money growth by altering the interest rate on monetary reserves. Thus, anyone watching for an expansion or contraction in the monetary base as a clue to Fed policy may be watching the wrong Fed activity .


  1. Wenzel,

    This seems to be tacit admission by the Fed that they CAN'T withdraw monetary reserves.

    I am curious what you think are their chances at "controlling" anything through interest rates. Doesn't the bond market have ultimate power over that form of control?

  2. They can pay any amount they want on the reserves since they will just print the money to make the interest payments.

  3. FOMC meeting, August 8, 2006:

    "At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive:

    "The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5-1/4 percent."

    The vote encompassed approval of the text below for inclusion in the statement to be released at 2:15 p.m.:

    "The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." "

    Paulson, in another forum, has stated that August, 2007, began the strain on the Housing Market. In short, per Wanniski, Something Happened to cause the tremors in Housing before August, 2007. You will not find that information in any of the FOMC minutes. In fact, the purpose of these minutes appears to be directed to allowing the FOMC to issue the Formula given at the end of the quote.

    That the FED has failed in a most spectacular manner is an understatement. The Fed cannot simultaneously "foster price stability and promote sustainable growth in output." When you read the Micromanagement Techniques advanced in the above quotes, compared with the actual results, it is an admission that the Fed, as constructed, cannot possibly do its job.

    NOW go back and read the Swagel speech quoted on this site, along with Paulson and Bernanke and you will see that the results of this Massive Failure were intentionally manipulated after the fact to funnel money into directed Banks.

    It is the greatest theft in history.


  4. So what if, to correctly control growth in bank credit, the Fed needs to pay 10% on reserves? Whatever rate Ben pays will create a floor for all loans. Can our economy handle 10% or higher? Is Ben willing to pay 10% or higher to limit M2 growth?

    And how would this affect the banking sectors liquidity? Can they handle 10% overnight rates?

  5. @JS

    That's the kicker. Just how high are they willing to take rates under this plan.

    It should be noted that if they tried to sell debt that would push rates higher also.

    Certainly, not high enough. Thta's why inflation is coming back, and bonds and the dollar are dead.