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.

Exponential Growth in the Adjusted Monetary Base: What Is It Telling Us?

Updated September 27th, 2012

As my regular readers know, I like graphs.  I guess it's the scientist in me.  To me, graphs are a very simple way of explaining things, particularly things that are transpiring in the economy, particularly when comparing the present to the past.  I source quite a number of my graphs from FRED, the  Federal Reserve Economic Data, a database which is maintained by the Federal Reserve Bank of St. Louis.  This database contains data on more than 41,000 time series on many aspects of the economy, some mainstream and some very rarely used.  FRED's data is gleaned from the Federal Reserve, the United States Census Bureau and the Bureau of Labor Statistics among other sources 

I was researching information from FRED for a future posting and stumbled on two graphs that I found, one of which is the one of the most shocking graphs that I have seen.  Before I show you the graph, let's me supply you with a bit of background information so that you can put what you are seeing into context.

Central bankers often use the term Adjusted Monetary Base (AMB).   The Adjusted Monetary Base is defined by the Federal Reserve as "...the sum of currency (including coin) in circulation outside Federal Reserve Banks and the U.S. Treasury, plus deposits held by depository institutions at Federal Reserve Banks.".  It is basically M0 which is the narrowest definition of money and is the ultimate source of the nation's money supply.

Now, here's the first of the promised graphs from FRED showing the growth in the Adjusted Monetary Base since the beginning of 2009:

Certainly, it looks like the AMB has grown; it started at $1.59 trillion in early 2009 and grew by $1.14 trillion or 71.7 percent to $2.73 trillion at the beginning of 2012.  That's a very steep growth curve but things get worse when we look at the next graph which shows the growth in the Adjusted Monetary Base back to 1920:

Over the past century and certainly since prior to the Great Depression, the Fed's Adjusted Monetary Base grew at a slow, steady rate with a slight increase in the growth rate during the period from 1990 to the beginning of the Great Recession.  In the 1960s, the AMB grew by 1 to 2 percent per year, in the 1970s by 6 to 8 percent per year, in the 1980s by 6 to 10 percent per year and in the 1990s by 5 to 10 percent per year.

Here's a graph showing the annual percentage growth in the Adjusted Monetary Base since 2000 noting that the data shows growth from January 1 of a given year to January 1 of the following year:

Notice the massive growth in the AMB in 2008; the Adjusted Monetary Base grew from  $851 billion to $1730 billion in just 12 months, a 103.2 percent increase.  In 2009, the AMB grew by 16.2 percent, nearly triple the average annual growth rate of the previous decade, in 2010 it grew by a very modest 2.3 percent but that changed in 2011 when the AMB grew by 28.7 percent or $591 billion from $2.057 trillion to $2.648 trillion, a growth rate that is roughly four times the average annual growth rate of the previous decade and the second highest annual growth rated since 1920 by a wide margin.

The expansion in the Adjusted Monetary Base since 2008 is unprecedented.  If we look at another crisis of confidence in the American economy, after the attacks of September 11th, 2001, the AMB grew by only 9.2 percent in 2001 (for the entire year) and 6.8 percent in 2002, growth rates that were on par with the previous two decades despite the severity of the crises.  

It is generally believed that rapid growth in the monetary base has preceded accelerated inflation in the United States and other countries.  The massive growth is related to the "printing" operations carried out by the Fed during the bailout/rescue operations of 2008 - 2009.  The increased "printing" operations in 2011 were most likely related to the Fed's quantitative easing and "Twist" programs, both of which have been only marginally successful considering the risk to the economy over the long-term. 

I have a couple of questions.  Is the current level of the Adjusted Monetary Base the new baseline for the economy?  If it is, what will happen if all of those electronic digits sloshing around in the system create inflationary pressures, asset bubbles or other unforeseen issues?  If this is not the "new norm", what effect will contracting this vast amount of money lurking within the system have on the economy?

As I've said before, economics is the furthest thing from a science.  The impact of monetary policy have far-reaching impacts that are totally unpredictable and which cannot be foreseen by those that we are "trusting" with our future.  For one, I find the massive and rapid expansion of the adjusted monetary base a very frightening issue.  Only time will tell if my feelings are justified.