The Real Problem with Monetary Base Growth

Bob Murphy in a recent post highlights the fact that the out of control monetary base is getting more out of control.

Since mid-2008 to present, the monetary base has more than doubled, with a spike up, again, in recent weeks. The monetary base is now over $1.6 trillion. In early 2008, it was just over $800 billion.

Bernanke has been able to get away with this spike, largely because banks have not been lending money out as aggressively as they usually do. Consequently, the multiplier of money base growth to actual money growth has been under 1, when it generally is a multiple of 1.

Bernanke has said he is not concerned by this growth in the monetary base because he will just drain monetary reserves when the multiplier starts to climb again. But how is he going to be able to drain these reserves?

The assets he is buying to increase the monetary reserves are junk that is supporting the sub-prime market, the auto industry etc. There is no ready market for these assets. This means the only way for the Fed to drain reserves is to either issue debt itself (Bernanke has indicated he wants the power to do this) or have the Treasury sell securities and place that money on deposit with the Fed, which would result in those funds being drained from the system.

But, with long rates climbing now, and the Treasury having to raise two trillion in debt, just how does Bernanke think the Fed or the Treasury can go into the market to borrow even more money to drain reserves?

There will be a triple whammy on rates. The Treasury borrowing would push rates up (Whammy 1), but if the Fed went in to buy securities to push rates down, it would be counter productive to the Treasury's attempt to drain reserves. So the Fed wouldn't be pushing rates down at such at time (Whammy 2). Further, this would occur at a time when the multiplier is increasing which means there is more money entering the system, which means more price inflation, which means another source of upward pressure on rates (Whammy 3). The new money entering the system would sop up some of the new money raise by the Treasury, but at the price of greater inflation. But again if the Fed's goal is to drain reserves at such a time, it can't enter the markets to push rates down.

Bottom line, a Fed/Treasury attempt to drain reserves will dramatically push rates higher. If it halts the draining operation, this will mean even further growth in money supply which will be highly price inflationary, which will mean higher rates.

Bernanke is trapped in a box, there is no way out that is not traumatic to the financial system.