It seems, the Federal Reserve is everyone's bogeyman for inflation. Milton Freidman famously said "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." Change in the quantity of money is the purview of the Fed. Are they to blame? Let's unpack this.
Monetarists argue that if the Fed injects a lot of money into the system, that should produce inflation. Is that what is happening now? The money in the economy is currency in circulation and bank reserves, also known as M1. This is all the money the Fed injected into the system through its various actions. Because of this, M1 grew 200% from 2008 to 2012 and nearly 1500% from 2008 to 2022!
Prior to the GFC in '08, most of M1 was currency. Since then, most of M1 is bank reserves. So now, banks have a lot of money that they lent out, right?
Well, maybe not. This is where M2 comes into the picture. M2 is M1 + currency, deposit and money market accounts, otherwise known as the money that is or can be quickly converted into cash. Despite a 1500% increase in M1 from 2008 to 2022, M2 has grown only 286%.
This reality is also reflected in the money multiplier, M2 to M1. It fell dramatically in 2020 when the Fed flooded the market with money, and did not go up.
This means all those bank reserves, held by banks, are not being lent out into the economy. Why?
Turns out banks preferred to hold those reserves, perhaps due to risk-aversion in a generally weak economy. But something else happened also, which is that the Fed started paying interest on those bank reserves after 2009. This changed the incentives for banks, as they could hold reserves safely at the Fed and earn interest in line with safe T-bills.
If all of this money creation wasn't going to make its way into the economy, then why did the Fed do this? Well, it created those bank reserves, somewhat out of thin air, by engaging in transactions to buy Treasury bills in the market and then deposited bank reserves to pay for these bills. In doing this, the Fed created lots of demand for Treasuries. When you create demand for something, you increase the price. And when you increase the price of a Treasury bill, you drive down rates.
Why would the Fed want to do that, since it could just adjust the federal funds rate? Well, during the GFC, it reduced rates to zero, but post 2008, the economy was still in a rut. The Fed wanted to reduce rates to below zero, but could not do that. By implementing these operations to create reserves by buying Treasuries, it effectively reduced long-term interest rates to below zero. This improved the general economy.
So what now? As the Fed raises federal funds rates, it is likely to raise the rate on bank reserves. This will restrain banks from lending these reserves into the real economy. Additionally, as the Fed reduces its holdings of Treasuries, it will essentially take bank reserves out of the system. Both of these things will have the effect of reducing overheating in the economy, and theoretically constrain inflation.
The problem is that if monetary policy is not the issue, then we may have structural inflation due to other factors like longer-term supply chain, demographic, and climate change driven dislocations. This is what Larry Fink was arguing recently here. More on that in my next post.
Much of the logic above came from reading and trying to understand a speech by By John C. Williams, President and CEO, Federal Reserve Bank of San Francisco found here.
Any opinions or forecasts contained herein reflect the personal and subjective judgments and assumptions of the author only. There can be no assurance that developments will transpire as forecasted and actual results will be different. The accuracy of data is not guaranteed but represents the author’s best judgment and can be derived from a variety of sources. The information is subject to change at any time without notice.