US Monetary Policy Ambiguities

The stance of monetary policy is confusing these days. The target Federal funds rate is near zero, but that’s the nominal rate. With inflation low, the real rate cannot move as far into negative territory as it could if inflation were higher. It’s not “zero bound,” but it’s much closer than usual.

I’ve always regarded monetary policy in terms of growth in the money supply rather than the level of interest rates. Many people insist on calling monetary expansion with low interest rates “quantitative easing,” but to me it’s just that money growth changes are a powerful tool. I don’t know why a special term is needed.

The conventional wisdom is that money growth has exploded in recent months, and the growth in the Fed’s balance sheet is the evidence usually cited. However, most of that balance sheet growth was over in December. We’ve gone almost six months with no further net growth in the balance sheet.

Among the monetary aggregates, the monetary base has grown very rapidly, but the M1 and M2 versions of the money have shown little net growth. Their growth rates went up, but then back down. The monetary base is not something that people spend on goods and services. It is not money, but rather the basis for money growth-bank reserves and currency. While growth in the monetary base is normally followed by growth in various measures of the money supply, times are not normal now. The Fed is paying a nominal interest on reserves, including excess reserves, and banks are seeking more liquidity than usual.  Therefore, bank reserves and the monetary base are growing without translating into money growth.

Dennis Robertson, years ago, wrote about “money sitting” and “money on the wing.”

What we have now is bank reserves sitting and, to the extent new money has been created, money sitting. The velocity of money has dropped sufficiently that money growth has not translated into spending growth. New money doesn’t stimulate the economy if it isn’t spent.

So far, contrary to conventional wisdom, I have pointed out that, 1) the Fed’s balance sheet has not grown, net, in almost six months; 2) the growth in the monetary base has not led to rapid money growth; and 3) the growth in the monetary base is not by itself simulative. The banks and the public are holding onto their bank reserves and money respectively.

Further complications in our understanding have been introduced by the recent rise in the yield on the 10-year bond. Traditionally, a rise in interest rates would be taken as a sign of monetary tightening, but the interpretation by many now is that it’s a sign of “too much money being printed.” That interpretation, I assume, means a new inflationary premium is being introduced into long rates.

That may be right, but an alternative interpretation, implicit in what I’ve said above, is that monetary policy is still rather tight and the tremendous increase in borrowing by the Treasury has led to higher rates. The public won’t absorb all the new debt with out being paid to do so with higher rates. Right now, I think interest rates reflect excessive borrowing while the money supply is a better measure of Fed policy.