An Attempt to Understand Nugent’s Attempt to Explain Recent Monetary Policy

Here’s a piece at the National Review:

Economists point to the monetary base as the source of the Fed’s power to increase or decrease the money supply. The monetary base has two components: currency in circulation (i.e., money in peoples’ pockets) and adjusted bank reserves. Thus, if the Fed chair were dropping dollars from on high, the act would be reflected in the statistics. There either would be a rapid expansion in adjusted bank reserves or an increase in currency in circulation.

And yet, today, neither is the case.

The following chart indicates that while the Bernanke Fed has been lowering the funds rate, the monetary base as per bank reserves has been contracting

Both PGL and I have written about this before, PGL did it in response to an earlier piece by Nugent.

My explanation – there are several ways of moving the money supply, and moving the fed fund target is only one of them. The Fed also moves the MS by jawboning the public, moral suasion, and setting the required reserve ratio.

Think of it this way…. say the Fed announces that it feels that FF should stay where it is, and should remain there in the future. You could still the MS expand or contract quite a bit depending on what the Fed does.

For instance, you will have a contraction in MS if at the same as the Fed kept the FF constant and announced its intention to keep it that way indefinitely if any of the following happened:

a) the Fed Chair gives a speech saying the future looks bleak and the reason they don’t want to lower it (i.e., the FF rate) further is that they are worried about inflation
b) there are casual mentions at the monthly meetings that perhaps member banks should slow the loaning of money
c) the Fed ratchets up the required reserve ratio

Heck, the Fed can lower its FF and still get a decrease in MS under the right circumstances. Similarly, do the opposite of a), b) or c) and you get an increase in the MS. The fact that the Fed uses more on than one tool to control the MS isn’t a sign the Fed doesn’t control the MS any more than the fact that my car has both an accelerator and a brake, not to mention a clutch, is a sign that I have no control over the speed at which my vehicle is moving.

Nugent goes on:

All this is not to say that a dollar-dropping helicopter doesn’t exist. In certainly does, and standing at the ready are its pilot and co-pilot: the president and Congress.

When the U.S. gets in trouble, the government writes the checks. And when those checks are circulated the proverbial helicopter goes airborne and opens its dollar-dumping doors. Sometimes this is a good thing. Our pilot and co-pilot are to be commended for the several hundred billion they have thus far dropped on the Iraq and Afghanistan wars, and the $50 billion they marked for a targeted drop on the Gulf Coast regions devastated by Katrina and Rita.

Part of me says: he can’t be arguing that the president and the Congress are in charge of the MS. The rest of me says: there’s a reason we have the National Review listed in the unintentional humor category of our blogroll.

And the rest of me may have the facts on its side… after all, assume that the president and the Congress do control the MS (yes, I know, its a crazy assumption, but let’s follow what I think Nugent might be saying through to its logical conclusion, so to speak). How would you extend that argument to say that the hundreds of billions spent in Iraq and Afghanistan were expansionary monetary policy when much of that money was spent… in Iraq and Afghanistan and the surrounding region?