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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June 11, 2009

Price stability and the monetary base

Arthur Laffer, as several readers (and friends) have pointed out to me, is taking aim at the Fed:

"… as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

"About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base—which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash—by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position."

I have a few problems with that statement. To begin with, the notion that the Federal Reserve signaled a 180-degree shift in focus to move "from an anti-inflation position to an anti-deflation position" is about equivalent to saying that the temperature control system in your house has a fundamentally different objective when the heater kicks off in June and the air conditioning kicks on. The essence of an inflation objective—even an implicit one—is that a central bank will lean against price-level changes substantially below the desired rate, as well as changes substantially above the desired rate. You can certainly argue with the policymakers' forecasts and diagnoses of risks at any given time, but it serves the debate well to not muddle tactics (focusing on inflation or deflation as the economic weather requires) and objectives (the control of the inflation rate that is Mr. Laffer's true concern).

But that point is a quibble. The increase in the U.S. monetary base has indeed been something to behold, and the Laffer article gives a good explanation about why you might be worried about that:

"Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money.

"Banks are required to hold a certain fraction of their liabilities—demand deposits and other checkable deposits—in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions. They weren't able to inject liquidity into the economy, which had been so desperately needed in response to the liquidity crisis that began in 2007 and continued into 2008. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans…

"At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century."

OK, but in my opinion it is a bit of a stretch—so far, at least—to correlate monetary base growth with bank loan growth:


Let's call that more than a bit of a stretch.

The Laffer argument is in large part about what the future will bring. But we know that the payment of interest on bank reserves—which we have discussed in this forum many times (here and here, for example)—means a higher demand for reserves in the future than in the past. This change, of course, means that levels of the monetary base that would have seemed scary in the past will become the new normal. How big can the "new normal" be? That's a good question, and one I will continue to contemplate. But the assertion in the Laffer article that "a major contraction in monetary base" is required cannot be supported by either current evidence or simple economic theory.

There is, however, more. Whatever policy choices are required to deliver a noninflationary environment going forward, Mr. Laffer seems convinced that the central bank is not up to making them:

"Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds."

On this I will just turn to my boss, Atlanta Fed President Dennis Lockhart, who addressed this very issue in a speech given today at the National Association of Securities Professionals Annual Pension and Financial Services Conference in Atlanta:

"The concerns about our economic path are crystallized in doubts expressed in some quarters about the Federal Reserve's ability to fulfill its obligation to deliver low and stable inflation in the face of very large current and prospective federal deficits. In a word, the concerns are about monetization of the resulting federal debt.

"I do not dismiss these concerns out of hand. I also recognize that the task of pursuing the Fed's dual mandate of price stability and sustainable growth will be greatly complicated should deliberate and timely action to address our fiscal imbalances fail to materialize. But I have full confidence in the Federal Reserve's ability and resolve to meet its inflation objectives in whatever environment presents itself. Of the many risks the U.S. and global economies still confront, I firmly believe the Fed losing sight of its inflation objectives is not among them."

'Nuff said, for now.

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

June 11, 2009 in Inflation , Monetary Policy | Permalink


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Laffer's right. Since Bernanke was appointed to the Chairman of the Federal Reserve, the rate-of-change in legal reserves (the proxy for inflation), dropped for 29 consecutive months (out of a possible 39, or sufficient to wring inflation out of the economy).

It’s only been in the last 10 successive months (since Aug 2008), that the FED’s “tight” monetary policy was finally reversed. An overcautious Federal Open Market Committee acted too late to prevent an extremely high transactions velocity of money from declining (such a velocity is required just to maintain prices at their current levels).

First, there is no ambiguity in forecasts: In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise”:

(1) nominal GDP is measured by monetary flows (MVt);

2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters;

(3) “money” is the measure of liquidity; &

(4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;

Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.

Contrary to all economists, the lags for monetary flows (MVt), i.e. proxies for (1) real-GDP and the (2) deflator are exact, unvarying - respectively.

Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact; as demonstrated by the clustering on a scatter plot diagram).

Not surprisingly, adjusted member commercial bank "free/gratis" legal reserves (their roc’s) corroborate/mirror, both lags for monetary flows (MVt) –-- their lengths, or frequency, are identical -- (as the weighted arithmetic average of reserve ratios remains constant)

The lags for both monetary flows (MVt) & "free/gratis" legal reserves are synchronous or indistinguishable. Consequently, economic forecast are mathematically infallable (which includes housing bubbles, commodity bubbles, etc.).

This is the “Holy Grail” & it is inviolate & sacrosanct.

The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.

Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP.

Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.

Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the r-o-c in monetary flows to exceed the r-o-c in real GDP by c. 2 – 3 percentage points.

In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.

Some people prefer the devil theory of inflation: “It’s all Peak Oil's fault" or ”Peak Debt's fault". This approach ignores the fact that the evidence of inflation, is represented by "actual" prices in the marketplace.

The "administered" prices of the world's oil producing countries would not be the "asked" prices were they not “validated” by (MVt), i.e., validated by the world's Central Banks ( i.e., as Friedman maintained "inflation is always and everywhere a monetary phenomenon")

Posted by: flow5 | June 11, 2009 at 05:08 PM

Translation. If Congress does not get back to sustainable budgets, then the Fed will utilize the double dip scenario.

Posted by: Mattyoung | June 11, 2009 at 06:02 PM

An educated well explained response to an article written by a discredited imbecile economist who gets prime time coverage through the WSJ. This is the problem with the media in general. The "real" info is here but the masses are brainwashed with the crap in the WSJ.

Posted by: Amit Chokshi | June 11, 2009 at 10:39 PM


While I follow your arguments in the first part of the post, I am a little bit puzzled by its "conclusion." In his comments, Art Laffer is making a claim about the "Fed [being] in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the over the coming 12 months." However, you "counterclaim" is nothing more than a citation from Dennis Lockhart stating his confidence in the Fed and in its ability to keep its inflation objectives in sight. This sounds more like "propaganda" than an explanation on how the Fed plans to actually achieve these goals! In other words, I (unfortunately) don't see anything in this citation that refutes Mr. Laffer's statement ... Am I missing something here?

Posted by: Sam | June 11, 2009 at 11:49 PM

The arrangement whereby banks keep reserves on deposit at the Federal Reserve is the mechanism by which it controls the level of the policy fed funds rate. This is the first time that the Fed has also wanted to use reserve deposits as a material source of funding for its own balance sheet. Which requires that it pay interest on reserves, as explained in a number of your posts.

There is a difference between creating supersized excess reserves for the purpose of satisfying reserve demand from depository institutions, and creating them as a funding mechanism for the Federal Reserve balance sheet. The second purpose is more relevant for monetary policy in this case. Balance sheet expansion requires funding expansion of some sort. The use of reserves for this purpose is evident in the fact that the Fed has chosen to calibrate reserve demand by paying interest on supersized reserve balances almost from the outset. This reinforces the central function of reserve policy as the control over the level of the fed funds rate – including structural preparedness for an “exit strategy” from extraordinary balance sheet expansion.

The Fed web-site requires updating on the mechanisms of reserve management. In this regard, it would be helpful to discard the silly textbook “reserve multiplier” model, which countless economists still cling to, probably including your critic in this case. The “multiplier” idea has had virtually nothing to do with the way in which the Federal Reserve has actually operated for decades. The payment of interest on supersized reserves is a well deserved smack in the face for this obsolete notion.

Posted by: JKH | June 12, 2009 at 06:11 AM

Internationally traded commodity prices are shooting up. The dollar is falling. The stock market has quickly become overpriced based on fundamentals. Huge deficits will either be monetized causing inflation or they will crowd out private investment delaying economic recovery. The data suggests we are in the early phases of a severe inflation.

People do not understand that stagflation is a very real danger. The reason is that the path of recovery does not take us back to where we were in 2006. There are huge bottlenecks in the economy that will delay a healthy expansion for 2-3 years. Recovery will have to occur without an expansion of investment in housing and without consumer spending returning to unsustainable levels.

The fed did the right thing in flooding the financial markets with liquidity late in 2008. But the massive and unnecessary bailouts combined with a permanent expansion in federal government spending will make it very difficult for the fed to drain this liquidity from the system.

We may quibble about technical details of Laffer's article but the fundamentals point strongly in the direction of stagflation. All it will take is the slightest reluctance of the fed to raise interest rates rapidly in the next few months.

Posted by: Charles R. Williams | June 12, 2009 at 09:52 AM

You have to ask yourself a few questions:

Do Obama and the Fed have the political will to reign in this monetary expansion when inflation takes hold?

Does anyone see the Fed increasing interest rates next year during an election year?

What will happen to inflation if the answers to the above 2 questions are “NO”?

Posted by: Austrian School | June 12, 2009 at 01:54 PM

I cannot see how the Fed will manage to drain liquidity by selling those debt papers it bought at mark-to-model prices. Which rational investor will buy these assets - "toxic" or not - at roughly the same prices the Fed paid for them? If there'd been a market the Fed would not have needed to buy what nobody else wanted.
The Fed's intervention simply has to backfire as it is the only player in the market with pockets that can never be empty.
Alas, they are not the only ones with said problem as a look at the belance sheets of other major central banks clearly shows. This simply has to result in sustained money supply growth equals monetary inflation.
We are in uncharted territory - or at least I am - as the only case where fast money supply growth did not result in higher inflation was in Germany in the years after reunification. Rich Germany could afford it, not least to the conservative/tight monetary policy of Karl Otto Pöhl who disillusioned euphoric bankers by raising the key rate a full point to 7% when markets were expecting a step down. Had he not demonstrated that the Bundesbank would never leave the path of fighting inflation, Germany might have taken the disastrous course the USA has followed in this millennium.

Posted by: The Prudent Investor | June 12, 2009 at 06:54 PM

"But we know that the payment of interest on bank reserves—which we have discussed in this forum many time...This change, of course, means that levels of the monetary base that would have seemed scary in the past will become the new NORMAL".

Friedman's "monetary base" was never a base for the expansion of new money & credit:
Flawed as the AMBLR figure is (Adjusted Member Bank Legal Reserves), it is still far superior to the Domestic Adjusted Monetary Base (DAMB) figure, which is generally cited. The DAMB figure includes AMBLR plus the volume of currency held by the nonblank public (Milton Friedman’s “high powered money”).

Since the public determines its holdings of currency an expansion or contraction of DAMB is neither proof that the Fed intends to follow an expansive, nor a contractive monetary policy. Furthermore any expansion of the non-bank public’s holdings of currency merely changes the composition (but not the total volume) of the money supply. There is a shift out of demand deposits, NOW or ATS accounts into currency. But this shift does reduce Member Bank Legal Reserves by an equal or approximately equal amount.

Since the member commercial banks operate with no excess legal reserves of consequence since 1942, any expansion of the publics holdings of currency will cause a multiple contraction of bank credit and checking accounts (relative to the increase in currency outflows from the banks) ceteris paribus. To avoid such a contraction the Fed offsets currency withdrawals by open market operations of the buying type. The reverse is true if there is a return flow of currency to the banks.

Since the trend of the non-bank public’s holdings of currency is up (ever since the 1920’s), return flows are purely seasonal and cannot therefore provide a permanent basis for bank credit and money expansion.

In our Federal Reserve System, 90 percent of MO (domestic adjusted monetary base) is currency. There is no expansion coefficient for currency. And the currency component of MO is so prominent, and the proportion of legal reserves so negligible (and declining); that to measure the rate-of-change in currency held by the non-bank public, to the rate-of-change in M1 (where 54% is currency), is, yes, to measure currency vs. currency (hoc ergo propter hoc); in probability theory and statistics, not a cause and effect relationship.

Complicating the measurement of the monetary base is the fluctuation in the percentage of foreign currency circulation to domestic currency circulation (estimated at ½ to 2/3 of all U.S. currency).

I.e., the domestic monetary source base equals the monetary source base minus the estimated amount of foreign-held U.S. currency. Inflows and outflows of foreign-held U.S. currency (seldom repatriated) are related to political and price instability, as well as seasonal flows; (though arguably, it is till money for the prudential reserve “Euro-dollar Market”), and all are immeasurable in the short run...

The “shipments proxy” estimate of foreign-held U.S. currency uses data on the receipts and shipments of currency, by denomination, at the Federal Reserve’s 37 cash offices nationwide (note: > 80 percent of foreign-held U.S. currency are $100.00 bills). Because of its influence on the DAMB, quarterly estimates of foreign-held U.S. currency are reported in the Feds “Flow of Funds Accounts of the United States” & in the BEAs estimates of the net international investment position of the United States.

The volatility of the K-ratio (publics desired ratio of currency to transactions deposits, currency-deposit-ratio), and the volatility in the ratio of foreign-held to domestic U.S. currency, both influence the forecast of the (1) cash drain factor, and (2) the movement of the domestic currency component of the DAMB. This causes unpredictable shifts in the money multiplier (MULT – St. Louis), [sic], for M1 and thus M2.

The Federal Reserve Bank of Chicago uses legal reserves (“t”-accounts), exclusively, to explain the creation of new money in the booklet “Modern Money Mechanics”. The booklet is a workbook on bank reserves and deposit expansion (changes in bank balance sheets that occur when deposits in banks change as a result of monetary action by the Federal Reserve System – the central bank of the United States). The stated purpose of the booklet is to “describe the basic process of money creation in a "fractional reserve" banking system” - the monetary base has no role in this analysis.

It is therefore both incorrect in theory and thus inaccurate in practice, to refer the DAMB figure as a monetary base [sic]. The only base for an expansion of total bank credit and the money supply is the volume of legal reserves supplied to the member banks by the Fed in excess of the volume necessary to offset currency outflows from the banking system. The adjusted member bank legal reserve figure is that base.

Posted by: flow5 | June 13, 2009 at 01:06 PM

What is the proper volume of legal reserves? This depends on the “multiplier”, the transactions velocity of money, and the rate-of-change in real-GDP.

All of these variables can be estimated with a high degree of accuracy, and the rate-of-change in real-GDP serves as a close proxy to rates-of- change in total physical transactions, in both goods and services.

Since 1942, the “money multiplier” has been a comparatively constant measure using either:

(A) commercial bank credit (St. Louis FED), or

(B) the 60 largest CBs on the Board’s H.8 release,

[divided (by) legal reserves - my definition]

From 1947-1977 the multiplier doubled in 30 years; from 1977-2005 the multiplier doubled again in 35 years. At its current pace the multiplier will double in 6 years.

At the beginning of the “monetarist experiment” (see Paul Volcker Oct 6th 1979 pronouncement that the FED would henceforth de-emphasize the control of the federal funds rate and concentrate on holding the monetary aggregates in check. We were advised to “watch the money supply”),

Back then Money Market Services, Inc, was surveying sixty individuals for their weekly predictions on the expected volume of M-1. It happened that for the week ending Oct 10, the Board of Governors reported that M1 had increased $2.8b.

But on the subsequent week’s revision Manufacturers Hanover was found to have overstated its customer’s deposits (and the FED’s money supply figure), by $3.0b.

A simple but correct (not textbook), money multiplier is equal to commercial bank credit divided by applied vault cash + inter-bank demand deposits held at the District Federal Reserve Banks.

I.e., commercial bank credit divided by the system’s legal reserves equals the money multiplier. Using the correct multiplier in 1979 would have given speculators in CBOT Treasury Bond futures the necessary information to make a quick trading profit.

Until this recession/depression, monetary expansion responded immediately to an injection of reserves into the system. The FED could project with a high degree of reliability, the probable rate-of-increase in monetary flows (MVt), relative to the probable increase in real-GDP.

Because of our “market structure”, the first rate (monetary flows) should exceed the latter. How much? That is a policy judgment involving trade-offs, but perhaps by no more than 2-3%

Posted by: flow5 | June 13, 2009 at 01:13 PM

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