Tuesday, September 16, 2014

The Federal Reserve Plays the Blame Game

Updated February 2015

The Federal Reserve finally has it all figured out.  A brief paper by Yi Wen, Assistant Vice President and Economist at the St. Louis Federal Reserve and his Research Associate, Maria Arias, points out who is to blame for why the Federal Reserve's multi-trillion dollar monetary experiment has been such a colossal failure since 2008.  Here's their explanation.

The authors open by explaining the theory of money and inflation.  They note that inflation occurs because, according to the monetarist view, there is too much money available to buy the amount of goods and services that the economy produces.  The quantity theory of money relates price levels (P), the quantity of goods and services produced (Q), the total money supply (M) and the speed or velocity at which that money circulated in the system (V) in an equation:

                                          M*V = P*Q

This equation tells us that if the supply of money (M) increases at a faster rate than economic output (Q), the price level (P) must increase if the velocity of money (V) is held constant.  

Here's a graph showing the annual rate of growth of the monetary base since 2005:

With output growing at an average rate of just below 2 percent annually between 2008 and 2013 and since the supply of money grew at an average rate of 33 percent per year as shown on the graph above , the rate of inflation should have been about 31 percent per year rather than the 2 percent rate that is the average since 2008.  Why did this happen?

Let's start by looking at the changes in the monetary base, the sum of reserve accounts of financial institutions held at Federal Reserve banks plus all notes and coins.  It is basically the money that is easily accessed.  Here is a graph showing what has happened to the monetary base since 1984:

At $3.883 trillion, the monetary base is 4.8 times larger than it was just prior to the Great Recession and is now at its highest level since 1984.  Here is a partial breakdown of the monetary  base showing the growth in the size of commercial bank reserve balances and the growth in currency since 1984:

As you can see, most of the growth in the monetary base has been from America's commercial banks depositing funds with the Federal Reserve banks.

Now, let's look at the velocity of money, an issue that I have posted on here.  The velocity of money refers to the speed at which a given dollar in the economy moves from transaction to transaction.  The more often that a dollar is used to buy a service or a consumer item, the higher its velocity and the higher its velocity, the faster the economy grows.  When the velocity of money is low, fewer transactions are taking place and the economy is likely to shrink.

According to Federal Reserve data, this is what has happened to the velocity of the stock of money (MZM) since 2005:

At a ratio of 1.379 in the third quarter of 2014, the velocity of money is at its lowest level since record-keeping began in 1959.  This means that a dollar was spent only 1.38 times over the past year, down from 2.0 just prior to the Great Recession.

Now, let's answer the question, "Why did the dramatic increase in the size of the monetary base not lead to massive increases in price (i.e. inflation)?".  The authors suggest that:

"The answer lies in the private sector's dramatic increase in their willingness to hoard money instead of spending it.". (my bold) 

This has created the dramatic slowdown in the velocity of money as noted above.  According to the authors, people have decided to hoard money rather than spend it for two reasons:

1.) A gloomy economy after the financial crisis.

2.) The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds.

While this is an interesting hypothesis, here is what has happened to the personal savings rate since 2005:

At its current level of 4.9 percent, the savings rate is actually lower now that it was for most of the period between 2009 and 2013.  In fact, if we go back to the 1960s, the current savings rate is around half of the levels seen through most of the 1960s, 1970s and 1980s.

Here is a graph showing the actual amount of personal savings:

At its current level of $625.1 billion, the amount of personal savings is actually lower now than it was for 2011 and 2012.

It appears that personal savings increased by around $400 billion since the beginning of the  Great Recession at the same time as the monetary base increased by over $3 trillion. Obviously, unless Americans are hoarding stacks of cash in their mattresses and not depositing it in any commercial bank, the authors "private sector hoarding theory" is a wee bit suspect.

The authors close by noting that the velocity of money has slowed far more than would normally be expected as interest rates fell because the nominal interest rate on short-term bonds has fallen to the zero-bound meaning that the best form of risk-free liquid assets is no longer short-term government bonds but actual money.

Now you know who is to blame for the ineffectiveness of the Fed's six year long monetary policy - it's all of those American cash hoarders hanging on to every dollar that the Fed so kindly "prints" for them.


  1. I think M*V = P*Q is not a true statement. My question is who are the hoarders? Is it not stocks that have gone sky high for no real reason? These are questions not scarcasm statements. I was under the impression that all the money printing was what is driving up the stock markets, is that not the case?

  2. How elitist can the Federal Reserve be?
    The bottom 80% are not hoarding money, for they have little excess to hoard.
    The demand is not there to satisfy the supply of dollars, so inflation is low.
    To actually put its stupidity in writing takes a lot of guts!
    Don Levit

  3. I think it unfair to solely blame the Fed as it is the human condition and society at large that led to this mess. The so called "American Dream" and all it's great expectations, not only applied to individuals but to society and government as a whole. Just as individual consumers assumed toxic levels of debt to finance family trips to Hawaii, 10 plasma TV's and Hummers; so too did the US government amass toxic levels of debt to fund social programs, wasteful defence spending etc. Just as individual consumers purchasing behaviour kept kicking the debt can down the road via mortgage refinances and increased limits on credit cards; so too did the US government increase debt ceilings and expand bond buying programs. Ultimately, this whole conversation is about entitlement to (personal AND government) conspicuous consumption.

    Individuals tend to assume that government agents are not bound by the same behavioural constructs as everyone else. They would assume incorrectly.

    Therefore, to blame the Fed, whilst letting individual consumers off the hook, offers a myopic position on a pertinent subject.

  4. PJ, I have been reading your posts for quite some time as I quite enjoy your dedication to analysis. Nevertheless, have you ever wondered why those that promote austerity versus Keynesian deficit spending will never definitively prove their arguments? Even economists (of which I incidentally have an Hons degree) that have dedicated their entire academic careers on such matters will never come to a consensus regardless of the quantitative data points that supposedly expound their respective causes.

    I contend the reason for this is predicated on a primary condition; namely, the human condition. Thus, in relation to my previous comment about the futility of "blaming" the Fed while not applying the same rigorous analysis towards "individual consumers" renders your analysis one side short of incontrovertible. Much the same of leftists that contend that bankers are the bane of society and that they only look to maximize their financial positions. Objectively PJ, is this different than ANY worker or industry that endeavours to maximize their position? PEOPLE are greedy plain and simple. Regardless of their job, education, race, sexual orientation, political slant, social position etc. Each tries to maximize their utility indiscriminately.

    Here's a thought experiment for you: suppose one was able to change the strategy implemented by the Fed moving forward. No more debt accumulation. Now how do you suppose this will make any difference on Main St when the average American lives beyond their means? So the Federal Government is solvent, but the average American is drowning in personal debt. And not because they "don’t have enough to make ends meet", but rather, because they spent on goods and services that they should not have purchased. Their children really "needed" that second iPad, and flat screen TV in their bedroom etc. Does this fiscal change by the Fed really amend society? Who might one blame now?

    Political pundits and economists alike take a top-down approach when dealing with this subject matter. They blame the system when they should be taking a bottom-up approach and hold people accountable first. Is it not the case PJ that the Fed, Democrats, Republicans, bankers, central bankers and industries, unions are comprised of PEOPLE? Thus, what difference will a change in the system make when it is people’s behaviour that underpins all political systems?

    The bottom line is that you can change the “system”, but I can assure you that the outcome will always be the same, unless changes to counter the human condition are implemented.

  5. Points well made. I guess I took exception to the Federal Reserve pundits blaming the failure of their experimental policy (and it really is an experiment since it is unprecedented in central bank history short of Japan's experience which has also been a failure) on Main Street.

    It's funny when you look back to the generation that went through the Depression. My parents where chronic savers; paid off everything, rarely even used a credit card. That generation held off on buying things until they either REALLY needed them or could REALLY afford them. My suspicion is that if the Baby Boomers had looked at debt with the same view, the economy would not be in the condition that it currently is in. Unfortunately, in our consumer-driven economy, it seems more important to have the appearance of wealth than to make the sacrifices necessary to make one truly monetarily wealthy. Or, as you would put it, changing the human condition.

    Thanks for your input. I guess I just have a bit of a bug where the sun doesn't shine when it comes to central bankers who do everything in their power to cajole us into spending because that's the only way that the economy grows.

  6. I really appreciate your comments PJ. It shows your character to consider a position different than your own. When I was a university student, I held all of the same positions as you do. Yet, what I have come to understand is that for economic policy to be truly feasible, incentive structures must be implemented to offset or mitigate particular behaviours (rather than arguing about the validity of systems).

    As for your parent’s generation, their incentive structure supported responsible management of finances. There were few (if any) social safety nets at that time, so over-extending oneself financially may have resulted in literally starving to death. Thus, with the post-war societal transition towards the leftist nanny-state (financed by the explosion in wealth and technology) and the implementation of many social programs, incentive structures completely shifted in the other direction. As you state, the US became a consumer driven economy. The American Dream can be very expensive, and this fact is evidenced by the emergence of consumer debt. Societal values shifted towards immediate gratification and self-entitlement.

    Therefore, I take notice of those that argue from particular economic/political slants. Is it not the case that the US government is “of the people, by the people and for the people”? This essentially means the government is a sample size of the general electorate; thus, their own motivations, predilections, ambitions and incentive structures mirror society at large. If we hate the government for their ineptitude and bias towards their own personal agendas, then we must also hate ourselves for the same reasons. If we hate bankers for being corrupt and greedy, so too must we hate ourselves for the same reasons. If we hate unions for inefficiency and collusion, so too must we hate ourselves. Etc, etc. After all, each is comprised for and by people.

    Lastly, when individuals start thinking in theses terms, a more meaningful discussion can take place as to policy changes that will benefit society as a whole, rather than the vitriolic nonsense of democrats vs. republicans or liberals vs. conservatives vs. socialists, or Keynesians vs. Hayek’s etc.

    Thanks for your time and consideration PJ.

  7. You mean it took the FED this long to figure out "trickle-down" doesn't work from the FED any better than it does from government?

    We've been operating on this same failed economic approach for 35 years with the same failed result for our standard of living and median wages.

    If the FED had pulled 5 random guys from the street and said:

    We're going to do this:
    1 - give billionaires lots of money
    2 - ???
    3 - higher wages.

    They would tell you step 2 is a lie, and step 3 didn't happen the last 35 years they've been trying it!

  8. Fed is buying S&P futrues big time....the plan is to double down