The Fed and Money Printing

As I said in the last post regarding Jon Stewart’s take on Ben Bernanke’s "60 Minutes" interview, the Fed has lost the PR war on QE2. The reality is, as Ben Bernanke said, there will likely be no appreciable increase in credit – what he calls ‘money’ in the 60 Minutes interview.

I don’t see ‘credit’ as ‘money.’ To me, any dollar credits are money. Regardless of whether you call dollar credits the Fed creates ‘money’ or credit ‘money,’ what is clear is that you need both the supply of credit to and the demand for credit by creditworthy borrowers to increase much more for the US to escape a liquidity trap. This is not likely to happen any time soon since the household sector has major balance sheet problems, especially given high rates of unemployment and underwater home values. You can goose credit by goading lenders into lending recklessly or to non-creditworthy borrowers, yes. But, a sustainable increase in credit can only come after the excesses of the housing bubble are worked through. After the 60 Minutes piece, it is clear Bernanke knows this.

The problem Bernanke is having goes to terminology and the difficulty of explaining a complex monetary system. In 2002 and again last year, Bernanke used ‘money’ to denote the reserves he is now creating to buy government Treasury securities. In the most recent interview, he backed away from this terminology in a way that simply isn’t credible – perhaps as a defensive reflex to videos like "Quantitative Easing Explained". It will cost the Federal Reserve dearly. This is a major blunder.

I have harped on this credit issue a lot. The Fed is conducting an asset swap that increases reserves and decreases Treasury securities. It’s a one-for-one swap, nothing more. This is the crux of the matter. David Greenlaw of Morgan Stanley writes up a good piece that puts this thing in terms you may understand. Below is the first snippet followed by a link to the rest of his piece. You should note that he prefers not to call the Fed’s dollar credits money and is more attuned to broader money supply aggregates.

In his recent 60 Minutes interview, Fed Chairman Bernanke denied that the Fed was printing money. This is entirely consistent with our own view (see Morgan Stanley Strategy Forum, 11/1/2010), but it appears to have generated some confusion and anxiety. In fact, a commentator on CNBC indicated that Bernanke’s denial of money printing would trigger a credibility crisis for the Fed.

QE2 departs from the textbook. The issue is confusing because all of us who took a basic undergraduate Money & Banking class learned that a central bank’s open market purchase of securities was effectively the same thing as printing money. But the experience of the last few years has taught us that this logic is not always correct. In fact, Fed officials have been reluctant to adopt the QE terminology because the impact of asset purchases is all about rates – not quantities.

In the US, the Fed pays for bond purchases by crediting the reserve account of the bank that sold it the securities. Assuming that the rest of the Fed’s balance sheet doesn’t change, this leads to an increase in bank reserves. So, the monetary base – which consists of currency plus bank reserves – goes up by the amount of the open market purchase. In every textbook written prior to 2009 that we have come across, the rise in the monetary base is assumed to be transmitted into a roughly equivalent rise in the money supply. But, as we now know, this assumption is not always valid. In the first round of Fed balance sheet expansion, which began in late 2008 and continued into 2009, the monetary base more than doubled and the money supply barely budged. In textbook terminology, the so-called money multiplier – the ratio of the money supply to the monetary base – declined by about the amount that the monetary base rose. The Fed can create excess reserves, but it can’t force the banks to turn these funds into loans or securities holdings. In this case, the excess reserves are being stockpiled in banks’ cash accounts.

Why did the monetary transmission mechanism break down? There is no easy answer, but it appears that a number of factors may be at work. First, banks seem to have a heightened need for liquidity. Second, banks are concerned about their ability to meet pending capital adequacy standards. Third, just about every bank manager who we have met with over the past couple of years has complained about a lack of lending opportunities ("the same banks going after the same deals" is the common refrain). Fourth, in the aftermath of the credit crisis, there still seems to be a general elevation in risk-aversion at financial institutions. Fifth, the Fed began paying interest on reserves in 2008, and this creates a slightly higher hurdle to lending or securities purchases than existed previously.

It’s certainly possible that the current round of asset purchases will lead to a rise in the money supply, in contrast to the situation under QE 1. But we’re not holding our breath. The Fed does not seem particularly interested in eliminating interest on reserves, or trying to engineer negative short-term rates, because of the practical complications. And the other factors that appeared to contribute to a breakdown in the transmission mechanism still appear to be very much in place. We estimate that year-on-year growth in the monetary base will hit +30% over the next few months. While this is far less growth than seen in the first round of Fed balance sheet expansion, it is astronomical from a historical standpoint. Yet, we doubt that M2 growth will get much above +5%.

Source: The Fed and Money Printing – David Greenlaw, Morgan Stanley

P.S. – this might help deciphering the terms: the monetary base is reserves and currency but most people are concerned with broader definitions of money i.e. the money supply as defined by M2 or credit. The Fed is adding reserves, but ‘money in circulation’, M2, does not necessarily increase as a result. It depends on what banks do.