In late 2008, the Federal Reserve dramatically increased the monetary base of the United States (the monetary base includes currency in circulation plus bank reserves). For historical context, it took from May of 1994, with a monetary base of $400 billion, until April of 2006 for the base to double. In comparison, the monetary base nearly doubled from $900 billion in September 2008 to $1.7 trilion as quickly as January 2009. The Fed’s actions during those few months caused many to fear impending inflation, or even hyperinflation. In retrospect, their fears were, and remain, unjustified.
The Fed’s Loose Policy Was Actually Tight Policy
Despite what appeared to be overly-loose monetary policy, others, including myself, label the past two years as a time of tight money. Fittingly, we continue to call for monetary stimulus. Are those like myself turning a blind eye to what has happened with the monetary base since late-2008? Not at all, as you must take notice of what policy the Fed implemented in coordination with a ballooning monetary base. Since late 2008, banks have been paid interest by the Fed to hold on to their excess reserves. Instead of loaning out excess reserves or buying treasury bills, it has become more profitable for banks to collect on excess reserves at the Fed’s interest rate.
Empirical evidence supports this narrative of tighter-than-perceived monetary policy. Excess reserves increased from a “minuscule” $1.9 billion in August of 2008 to $59 billion the next month, followed by $267 billion, $559 billion, and $767 billion in the following months. In May of 2010, the last month with available data, excess reserves stood at over $1 trillion, while the monetary base was $2 trillion. These are unprecedented numbers! However, they illustrate that one half of the monetary base is sitting in bank vaults, not stimulating a still-struggling economy.
The Correct Measure of Money Supply is M2
As mentioned, the monetary base measures currency held by the public and bank reserves. The Fed can easily and directly affect this measure of money. However, a better gauge of monetary policy’s effect on the economy is M2. This measure includes money, and its close substitutes, but does not include reserves. M2 has also increased since the Fed started pumping money into the banks, but the increase has not been nearly as severe.
In fact, during July of 2008, just weeks before the economy entered its free fall, M2 slightly decreased from $7.8 trillion to $7.79 trillion. While not a huge decline, this was a period when a large increase was needed. As mentioned previously, from September 2008 to January 2009, the Fed increased the monetary base by approximately $800 billion. Alas, M2 increased by only $409 biilion. Of the $800 billion monetary injection during the darkest days of the recession, only $400 billion found its way into the economy.
Where To From Here?
After failing to do enough in late 2008, the Fed allowed monetary policy to stay too tight through 2009 and so far in 2010. Since the beginning of 2009, M2 has shrunk in six of the seventeen months. In an atmosphere of 10% unemployment, loose monetary policy is vital; yet, the Fed refuses to deliver.
At this point, the Federal Reserve may not even have to print more money. They simply must make the contractionary practice of paying interest on excess reserves short-lived. Ultimately, however, this step will also have no impact unless the Fed commits to delivering enough inflation to make-up for the recent period of deflation and below-normal inflation. The Federal Reserve has let imaginary fears of inflation override the real problems of high unemployment. The Fed has chosen poorly.
All statistics from the St. Louis Fed.