The recent swapping of assets by the Fed (Federal Reserve http://www.federalreserve.gov/) should have minimal effects on the monetary base. If the ‘so-called’ toxic assets that they have purchased such as MBS, will not recover lost market values, then the $30 billion of profits that they have managed to achieve in recent years, will be considerably less into the foreseeable future. Keep in mind that 90% of those profits are sent directly to the US Treasury. This can be seen in the NIPA under Federal Reserve Banks (Line Eight) http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=85&Freq=Qtr&FirstYear=2006&LastYear=2008
The Fed’s announced acquisition of over a $1 trillion in long-term US government securities is an entirely different matter altogether. Such acquisitions increase the monetary base (Federal Reserve Board H.3 Aggregate Reserves of Depository Institutions and the Monetary Base http://www.federalreserve.gov/releases/h3/current/h3.htm). The monetary base is equal to legal reserves of depository institution, plus the currency in circulation. So as the Fed acquires these securities, which increase the monetary base, the legal reserves of depository institutions will increase. This increases the capacity of the depository institutions (commercial banks, credit unions, savings banks and savings and loan associations). For each dollar of additional legal reserves in the depository system, a multiple of checkable deposits (M1 money) can be created (Federal Reserve Board H.6 Money Stock Measures http://www.federalreserve.gov/releases/h6/current/h6.htm). At the present time, with a 10% legal reserve ratio, an increase in legal reserves of one dollar can result in a maximum increase of ten dollars of the checkable deposits portion of M1 money. Since one of those ten dollars resulted from the Fed’s acquisition of securities, nine additional dollars of credit can be created if the depository institutions choose to create checkable deposit money and actually lend it. This is what is meant by the fractional reserve system
US Code of Federal Regulations
TITLE 12–Banks and Banking
CHAPTER II–FEDERAL RESERVE SYSTEM
SUBCHAPTER A–BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
PART 204—RESERVE REQUIREMENTS OF DEPOSITORY INSTITUTIONS (REGULATION D) http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=635f26c4af3e2fe4327fd25ef4cb5638&tpl=/ecfrbrowse/Title12/12cfr204_main_02.tpl
In the actual case, just described, the new money creation is ten times the increase in the additional reserves resulting from the Fed’s purchase of government securities, and a multiple of nine new dollars of credit.
The ambiguous outcome here as a result of the banks’ desire to use this additional capacity to create new money and credit only if it is profitable, will the banks use this capacity. The additional revenue from interest and fees, resulting from the new loans being made, will have to exceed all of the cost of the money and credit creation process. If this is not the case, i.e., if the loans are not profitable, the depositories will not use this capacity to create money and credit and the result will be excess reserves. At the present time, the depository system has a large amount of excess capacity to create money and credit. This is measured by excess reserves as shown in the Federal Reserve’s H.3 Release AGGREGATE RESERVES OF DEPOSITORY INSTITUTIONS AND THE MONETARY BASE http://www.federalreserve.gov/releases/h3/current/h3.htm
March 11, 2009
$(billions)
Total Reserves $678,689
Nonborrowed 48,513
Required 57,171
Excess Reserves 621,518
Monetary Base 1,535,273
Total Borrowing from Federal Reserve $630,177
This huge amount of excess reserves indicates the already huge excess capacity of the depositories. Even without further Fed action, the depositories could create a huge amount of checkable-deposit-portion of M1 money and credit…why aren’t they doing so? It’s not profitable.
The Fed cannot coerce the depositories to do so. It is the Fed attempting to push a limp string and not a steel rod. Most likely, a goodly portion of the Fed’s acquisition of the Fed’s long-term US Government securities over the coming year or so will be used to retire the bank loans from the Fed’s discount window mechanism. In any event, it will simply result in more excess capacity until the time that bank lending once again becomes profitable. This illustrates the asymmetry of the Fed’s monetary power. It is awesomely powerful in crunching the economy with monetary constraint, but is 98 pound weakling in stimulating growth in money and credit. (The Federal Reserve System: Sausage making and its relation to monetary policy http://byrned.faculty.udmercy.edu/2003%20Volume,%20Issue%205/newsletter%20fiveA.htm)
So what about the inflation?
We’ve already pointed out to you in the above that the Fed cannot force any significant increase in money and credit until profitability returns to the depository institutions. But even if profitability returns and the depositories increase the supply of money and credit significantly, it will not necessarily lead to inflation. To argue it will, means that monetarism is still a valid (link to monetarism). It’s been very clear over the last 15-20 years that the velocity of the monetary aggregates (especially M1, M2 and M3) has not been related enough in a stable/consistent manner to nominal GDP. For monetarism to be a valid explanation of inflation, requires if not a stable velocity or linkage, it must have a statistically predictable linkage to GDP. This has not been the case in recent years. (Economic schools of thought…of long dead economists and other items of interest
http://byrned.faculty.udmercy.edu/2004%20Volume,%20Issue%201/Newsletter%20Vol%202004%20Issue%201.htm)
There is no assurance then that a rapid increase in the growth of money and credit – even growing more rapidly than GDP, will necessarily result in accelerating inflation.
The economy in the last 25 years or so has shown that a decrease in the velocity of any of the monetary aggregates has offset the expansive effects of increases in those same monetary aggregates.
To further support the warning that increases in the creation of money and credit will not cause significant inflationary pressures one must understand the altered behavior of the PPI and CPI.
(The FED: CONUNDRUM, CONSTERNATION, OR CONFUSION?
http://byrned.faculty.udmercy.edu/2005%20Volume,%20Issue%201/2005%20Volume%20Issue%201.htm)
“As another indicator of those evolutionary, but dramatic changes in the increasingly competitive U.S. markets, note the changes that have also been occurring on the international front. Increasing competition in the world, as well as domestically in the U.S. has brought together the behavior of commodity prices facing both the developing and advanced countries.
For the past five years, as contrasted with previous data, the Consumer Price Index CPI no longer reflects the Producer Price Index pressures. The CPI has been rising less than the PPI in three of the last five years. Remember also, that the CPI includes services at the retail level have in previous years, been the main source of inflation. Even with these included, the CPI is reflecting less inflation than the PPI. This is in stark contrast to what has typically been the case in the past.”
As always…more to follow