The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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January 13, 2009

On expanding balance sheets and inflationary policy

Here's a question I hear a lot (most recently during the Q&A portion of a speech delivered yesterday by my boss, Atlanta Fed president Dennis Lockhart): Has monetary policy become so expansive that the central bank's mandate to maintain price stability has been fundamentally compromised? Is the increase in the scale of the Federal Reserve's balance sheet inherently inflationary?

Jim Hamilton covered much of the territory implied by these questions in a very extensive Econbrowser post not too long ago, but the distinction between money creation and Fed balance sheet expansion continues to be confounded. Here, for example, is a passage from the Wall Street Journal's Real Time Economics coverage of Stanford professor John Taylor's (not exactly glowing) review of recent Federal Reserve action, delivered at this year's annual meeting of the American Economic Association:

"The Fed has launched nearly a dozen new programs in the past year to address the crisis. Its strategy is to target specific markets in distress—from commercial paper to asset backed securities to money market mutual funds and stresses overseas—with programs tailored to their problems. It also has gotten deeply involved in rescues of individual firms like Bear Stearns, American International Group and Citigroup.

"The Fed has funded these programs by pumping reserves into the banking system—essentially creating new money. In the process, its balance sheet has ballooned from less than $900 billion to more than $2 trillion."

The record though, as the article goes on to note, is that not all of that $2 trillion represents an increase in the money supply:


Only the blue portion of the graph above represents "pumping reserves into the banking system"—a fact that was covered pretty well in the aforementioned Econbrowser post—and in an even earlier post at News N Economics. In simple terms, the size of the Fed's balance sheet is not the same thing as the size of the monetary base (the sum of currency in circulation and reserve balances kept by banks with the Federal Reserve).

Of course, John Taylor's point was not that all of the increase in the balance sheet has amounted to pumping in reserves, just that a lot of it has, which is clearly true. But even here there may be less to the potential inflationary impact than meets the eye. In his speech at the London School of Economics earlier today, Chairman Bernanke explained:

"Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed's lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed's balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base."

Last week Greg Mankiw had a nifty graph (courtesy of Professor Bill Seyfried of Rollins College) of the so-called money multiplier precisely illustrating the point:


The money multiplier measures the amount of money in the hands of the public—the M1 measure in this case, which is composed mainly of cash and demand deposits (i.e., checking and debit accounts)—that are created by a dollar of monetary base. That amount fell considerably when the Fed introduced the payment of interest on bank reserves.

That said, despite the fall in the money multiplier, the M1 measure of money has also expanded fairly noticeably since late summer:

(Note: This chart replaces the original chart in the blog posting on 1/13/09, which had a mislabeled left axis.)

The increase in M2—a slightly broader measure of money that adds to M1 items like savings accounts and time deposits—has been somewhat slower but still on the rise:

(Note: This chart replaces the original chart in the blog posting on 1/13/09, which had a mislabeled left axis.)

From December 2007 through August of last year, M1 and M2 grew by about 1.2 percent and 3.9 percent respectively. Since September—after which the rapid expansion of the Fed's balance sheet began and the Fed began to pay interest on reserves—the corresponding growth rates have been 13.4 percent and 5.9 percent.

Are those growth rates substantial? That is a tricky question—whether a particular growth rate of money is substantial or not can only be determined in relation to the pace of money demand (which has almost certainly accelerated as interest rates have fallen and the taste for safe and liquid assets risen). But I take two lessons from our early experience with the asset-oriented policies emphasized in the Bernanke and Lockhart speeches. First, expansions of the balance sheet need not imply expansions of the money supply. Furthermore, as Chairman Bernanke emphasized, the Fed has the capacity to contract reserves going forward:

"… the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control. Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system."

The second lesson, clear in the M1 and M2 charts above, is that despite the payment of interest on reserves and near-zero federal funds rates, it is still possible to induce increases in the broad money supply through the standard channel of injecting reserves into the banking system.

Whatever direction you think the money supply ought to go, these observations should come as comforting news.

By David Altig, senior vice president and research director at the Atlanta Fed

January 13, 2009 in Federal Reserve and Monetary Policy , Inflation | Permalink


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Several points for emphasis:

First, most of the increase in the size of the Fed’s balance sheet reflects an increase in the size of the monetary base. The primary exception has been the program of government deposits held at the Fed, which has been confirmed to be temporary, notwithstanding the option of reintroducing it at a later date.

Second, increases in the monetary base coincide with at least first order increases in broad money supply, although some of this money might be used to pay down bank credit immediately, thereby eliminating the broad money form just created. More generally, macro “deleveraging” has resulted in slower overall net growth of credit and money than would normally be the case, given such a provision of excess reserves. The collapsing “money multiplier” reflects a reduction in the usual leverage associated with excess reserve supply, because monetary policy is working uphill in an attempt to offset these forces of contraction. It is the effect of policy on the counterfactual that should be judged.

Posted by: JKH | January 14, 2009 at 07:54 AM

A more prosaic point. I think that the money stock numbers on the graphs should be trillions not billions.

Posted by: RebelEconomist | January 14, 2009 at 11:37 AM


Why should we care about the direction of the M1 multiplier? Isn't the absolute level more important?

Say the Fed injects $1tr in reserves at a multiplier of 1.0, or injects $3tr in reserves at a multiplier of 0.5. Which is potentially more inflationary? I would argue the latter.

As far as demand for money balances, I'm surprised you didn't mention that GDP is contracting and that M1 growth FAR exceeds nominal GDP growth. Some might suggest this is inflationary. It is up to Bernanke and others (including your boss) to explain why its not. Further, the behavior of M1 and M2 differs markedly from that of deflationary analogies like Japan and the U.S. during the Great Depression.

Finally, it appears that the Fed is being less than honest when it talks about the difficulty of removing reserves. In the last recovery -- from a shallow recession -- the same Fed engaged in "measured pace" hand-holding until commodity prices began to go haywire. Why should one expect this next recovery to be any different when we will be: a) coming out of a deeper contraction; and b) coming out with much faster growth in broad money measures?

Posted by: David Pearson | January 14, 2009 at 11:50 AM

The discussion of the Fed's "proper" role ignores the fact that the Fed is practicing price controls (on money).

In Greenspans book, The Age of Turbulence, there's a passage on page 297 where Greenspan describes his debate with Li Peng and Greenspan told Li Peng that the US tried price controls (under Nixon) but learned that they don't work and learned not to do them.

Apparently not.

Posted by: George | January 14, 2009 at 12:13 PM

Simply put, the fed is leveraging up big time to allow the financial system leveraging down. I am curious: anyone know how much accouting capital the Fed has?

And please don't tell us that it can "easily reserve" these actions: we heard that in 2003-2004, look what that brought us.

Posted by: marie | January 14, 2009 at 03:15 PM

One of the best explanations I've ever seen.

On September 11th 2001, the FED expanded its balance sheet and I didn't hear any economist saying that US should care about inflation.

Probably this time the expansion of the balance sheet is staying for enough time so those economist that do not understand monetary policy and financial markets can worry about it.

Thanks David!

Posted by: El del 0.33% | January 14, 2009 at 11:10 PM

When Bernanke says "However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed.", surely he recognizes that only the Fed can create or destroy overall reserves in the system. Excess reserves are thus a pre-ordained number and banks can only shift around reserves from one to another.

Posted by: Mojakus | January 15, 2009 at 09:11 AM

Eh David: Care to address those comments above? It seems that your observations did not come as comforting a news as you expected .

Posted by: JAL | January 28, 2009 at 04:13 PM

Great idea, but will this work over the long run?

Posted by: Roulette_Albert | July 13, 2009 at 01:47 PM

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