Wednesday, February 22, 2012

The Fed Does Not Print Money

It only looks like they are printing money.  This is only so because the Fed is not the greatest when it comes to public relations.  Most of the money printing fears can be summed up by the next graph, showing M1 and M2.  Straight from my Macro 101 textbook, some definitions:
  • M1 = The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency + those portions of M0 held as reserves or vault cash + the amount in demand accounts ("checking" or "current" accounts).
  • M2  = M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000)

Oh my will you look at that.  But look how broad M1 is; it includes reserves.  As a reminder, the Fed decides the reserve ratio, which is the minimum ratio of dollars the banks has on hand to deposits outstanding, at last count was 10% for the biggest banks.  So if the bank had $500 million in deposits, then the bank always needs to have at least $50 million on hand.  Excess reserves just mean whatever they have in excess of the $50 million.  If they have $400 million left around, that means they have $350 million in excess reserves.  This collects somewhere around 0.25% interest at the Fed, kind of like a Fed checking account.

Reserves therefore hypothetically determines how much credit there can be in the private sector at any given time.  However, I submit to you that for all practical purposes, banks are never reserve restrained, meaning they will make loans as long as there are good loan applicants.  This is possible because almost all loans become deposits.  If I take out a $10K loan to buy a car, that loan just becomes the car dealer's deposit, thus increasing another bank's reserves. 

In a normal day of transactions, reserves never get run down.  Even in an improbable scenario where reserves start to get run down because of only withdrawals/loans and no deposits, the bank in question will just borrow from another bank, which mathematically will have excess reserves.  Thus in a normal business day, banks are not nervously looking over their reserves.  Banks will always run out of good loan applicants before hitting their reserve ratio (if such a thing is even possible).  And I guarantee nobody has ever been turned down from a loan because "sorry we do not have extra reserves." 

So why do we have this whole system set up?  First, it's there to cover any physical withdrawals by the bank's customers.  Second, it's there for the Fed to efficiently target interest rates.  Think about it: if the Fed wants to lower interest rates (most of the time the Fed Funds rate, but recently all across the yield curve), the Fed will purchase instruments from the private sector (most likely Treasuries), decreasing the supply of them in the private sector, increasing their value, thereby decreasing interest rates.  So simply, the Fed takes away their Treasuries and give them equal value of dollars; total assets of the private sector remains unchanged.  (Sound familiar?  This is Quantitative Easing, which is what the Fed has been doing since it was created.  The only difference is it targets the long end of the yield curve as the short end is already at zero.)  Since banks for all intents and purposes do not lend out reserves, excess reserves should be seen as an accounting identity of the fact that the Fed exchanged Treasuries for them.  Excess reserves will stay excess reserves until the day the Fed decides to raise rates and puts those treasuries back in the system.  Remember, reserves are a buffer so the banks can always act as a counterparty to the Fed. If you are confused, think about what happens if reserves really does "get lent out."  How would the Fed increase interest rates?  It won't be able to if the banks do not have enough reserves to pay for Treasuries the Fed is foisting upon them.  The banks know the deal; the Fed knows the deal.  Somehow the message got lost on the way to the rest of us.

So if we take away those reserves, which are mostly irrelevant to the private sector, what do the charts look like?

The yellow and green lines are what we get once we subtract reserves held at the Fed.  As you can see, for most of the time, reserves were never held at the Fed until the Great Recession.  This makes sense as the Fed has never been so active in targeting interest rates all across the yield curve until 2008 and thus never had to buy this much treasuries at once.

Look at M1 money supply after subtracting reserves.  Does this look like money printing?  Even M2 has been flatlining until turning up recently this year, which corresponds to relatively decent domestic economic growth, especially with the general turpitude in Europe. 

There are concerns that the huge amount of reserves will somehow be inflationary down the line.  Perhaps, but that assumes the Fed and Treasury will just stand by with their fingers in their ears.  Remember looking at the reserve itself is meaningless; it's just there to make the Fed's job of maintaining rates easier.  The banks will lend if there are good loan prospects.  If too much credit is being created, fanning the flames of another irrational boom before the bust, then the Fed hypothetically will be stepping in with interest rate increases (note also that the Fed and most western Central Banks rarely touch the reserve ratio to deal with inflation as they rather raise interest rates) or the Treasury will be hypothetically stepping in with tax increases to decrease private sector money supply.

Finally, we do "print" copious amount of money, but the Treasury does it.  It did the smart thing by keeping its mouth shut about it, not issue a press conference and call it something banally nefarious like "Quantitative Easing."