The Federal Reserve and “Printing Money”

I cringe a little every time someone comments on the Federal Reserve printing money. This is used as a metaphor, but taking it literally, as many do, leads to the belief that the Fed has more precise control over the money supply than it actually has.

The Fed, of course, does not literally print money. That is done by the Treasury Department's Bureau of Engraving and Printing. Paper currency is now in the form of Federal Reserve notes, which are liabilities of the Federal Reserve Banks. The Bureau charges the Fed for the printing cost. Coins are minted by the Treasury's Bureau of the Mint. These are sold to the Fed at face value. Coins are not liabilities of the Fed. The difference in the cost of minting a coin (including the cost of the metal) and the face value is called seigniorage. Seigniorage enters into government accounts as a means of financing, not as an outlay or a receipt. Other means of financing include the sale and redemption of Treasury securities and, as a legacy of its historical monetary role, the purchase and sale of gold. (Some seigniorage can be negative; for example, it costs more than a penny to mint a penny).

The amount of currency in circulation is determined by public demand. When a Federal Reserve member bank needs more currency to meet the demands of its customers, it gets it from its Federal Reserve Bank, which deducts the dollar amount from the bank's account at the Fed. (A significant amount of U.S. currency, especially $100 bills, is held abroad.)

But of course currency in circulation is not what we mean by the money supply. The narrowest measure of the money supply, M1, is defined by the Fed as "(1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions." The other commonly used measure of the money supply, M2, is M1 plus "(1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds."

The banking system essentially "creates" money by making loans and accepting deposits, most of which are lent out and reappearing as additional deposits in banks. (This is called fractional-reserve banking.)

Note that reserve balances at the Fed are not included in M1 or M2. However, when people talk about the Fed "printing money," what they mean is that the Fed is adding to the reserve balances of the banking system, accomplished by buying securities or making loans.

The relationship between the money supply and the monetary base (deposits held by depository institutions at the Fed and paper currency and coins in circulation) is not constant. The Federal Reserve Bank of St. Louis produces a data series, the M1 multiplier, which is seasonally adjusted M1 divided by the monetary base adjusted for changes in reserve requirements and seasonality. This chart shows that the multiplier has been trending downward, then plummeted, and is currently less than one.

We can also divide reserve balances held at the Fed by M2 (in this case not adjusted for changes in reserve requirements or seasonality) to get another picture of how the Fed's ability to increase the money supply has gotten more difficult in recent years:

 


There is concern, especially from those who believe that monetary policy has been much too loose, that inflation is a serious risk. The CPI has increased by 3.6% from a year ago, according to the latest figures for July. Those who are less concerned about inflation point out that the core CPI has only risen by 1.8% over the past year. (This post by Felix Salmon gives a good feel about the confusion surrounding the current inflation numbers.)
While there can be a debate about whether the "stagflation" we experienced in the 1970s is coming back, the data show that the Fed's ability to do much about the stagnant economy has declined significantly. Fears about the Fed "printing money" are overblown in the current environment, though the Fed, without much historical guidance, will have the difficult task of timing the withdrawal and the rate of withdrawal of reserves whenever it is that the economy begins to show some life.

Nevertheless, since, due to the political situation, additional fiscal stimulus is not a policy option, at least for now, everyone is looking for the Fed to do something to help the economy. Ken Rogoff even suggests that both the Fed and the European Central Bank target an inflation rate of "4 to 6 percent for several years." In a column sympathetic to Rogoff's view, Floyd Norris of The New York Times reports on Paul Volcker's reaction to this:

"'I don't think it's a good idea,' was one of the milder comments I got from the most celebrated veteran of those wars [against inflation in the 1970s and 80s], Paul A. Volcker, the former Fed chairman.

"And anyway, he added, 'Right now they probably could not get inflation if they wanted to.' People are not spending the money they have, he said, adding that the situation reminded him of an era he studied in college — the Great Depression."