Wednesday, December 4, 2013

A Brief Note on “Printing Money” and the Monetary Base, M2, and Inflation

When it comes to monetary policy, the media is fixated on the Fed’s “printing money”* and the timing of any tapering of “quantitative easing.” Critics of the Fed assert that the Fed’s quantitative easing policies will lead to inflation. The simple argument is that the Fed’s policies will lead to too much money chasing too few goods, which will result in price increases.
In order to evaluate this argument, it is useful to remind ourselves of some basic facts. It is true that the Fed through its quantitative easing policies  purchasing Treasury notes and bonds and mortgage-backed securities  has been vastly increasing the size of its balance sheet to an unprecedented degree. This has resulted in a large increase in bank reserves and the monetary base (currency in circulation and balances of depository institutions held at Federal Reserve Banks). It has not, though, resulted in an unprecedented increase in the money supply. M2, which is a commonly used measure of the money supply, consists of currency held by the public, transaction deposits at depository institutions, savings deposits, time deposits of less than $100,000, and retail money market fund shares. (See here for the Fed’s description of these aggregates and links to monetary data.) Note that bank reserves, including excess reserves, are not included in M2.

What is important to note is that the relationship of changes in the monetary base, which the Fed controls, and changes in M2 has been completely transformed since the financial crisis. The monetary base also currently has no relationship to inflation as measured by the CPI. This graph shows on a monthly basis beginning in 2000 percentage changes from a year ago of M2, the monetary base, and the CPI.
Before claiming that Fed policy is leading to inflation, critics need to analyze the change in the relationship between the Fed’s expansion of its balance sheet and the growth rate of M2. They also need to examine the current lack of relationship between the monetary base and inflation.
What seems more plausible is that monetary policy has not been as effective as desired at stimulating the economy. There also is little effect of quantitative easing on increasing the growth rate of the money supply. There is a case to be made, though, that the quantitative easing policies have served to lower long-term interest rates, particularly on Treasuries and mortgage-backed securities, but to an unknown degree. This has perhaps fueled increases in stock market and housing prices, but it has not resulted in an increase in prices of consumer goods. There is reason to be concerned about asset bubbles at the current time, but the danger (or benefit) of inflation seems remote.
Some economists, such as Paul Krugman and Ken Rogoff, advocate Fed policies leading to an increase in inflation as a way to get the economy growing. Higher inflation can produce negative real interest rates, which some view as necessary to get the economy to full employment. At the moment, it would seem that the Fed would have to be much more aggressive than is currently feasible politically or practically to get the inflation rate at some economists’ preferred target of four percent. Of course, it may become possible at a later time, though it is subject to debate whether this would be good policy. At the moment, the greatest risk to the economy from current Fed policy is asset bubbles which inevitably deflate. The Fed’s greatest challenges are deciding how to meet its legislatively mandated goals of stable prices and maximum employment in a period when fiscal policy is far from helpful in stimulating the economy, when and how to phase out its quantitative easing policies, and how to avoid dangerous asset bubbles.    

* The phrase “printing money” is misleading shorthand for what the Fed does. I prefer to call it “creating money.” The Treasury Department through its Bureau of Engraving and Printing prints money. The Federal Reserve pays the Treasury for the printing costs. How much the Federal Reserve orders of Federal Reserve notes is largely determined by the public’s demand for physical currency. Coins are minted by the Treasury’s Bureau of the Mint and sold at face value to the Fed. The difference between the face value of the coins and the cost to the Treasury of producing the coin enters into government accounts as a means of financing, i.e., it is not an outlay or a receipt and does not serve to increase or reduce the reported budget deficit. This is called seigniorage. In minting pennies and nickels, this seigniorage is a negative number.

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