St. Louis Fed poses a key concern on the monetary base


The St. Louis Fed includes the review on monetary policy. Figure 1 shows ‘currency in circulation’ to be basically flat at this time, which indicates much of the new money is in excess reserves and has not entered the broader money supply. This also begins to address in a clear way the concerns and the talk of future inflation.(h/t Movie Guy)

More money: Understanding the increases in the monetary base

The financial crisis that began in the summer of 2007 took a turn for the worse in September 2008. Until then, Federal Reserve actions taken to improve the functioning financial markets did not affect the monetary base. The unusual lending and purchase of private debt was offset by the sale of Treasury securities so that the total size of the balance sheet of the Fed remained relatively

In September, however, the Fed stopped selling securities as it made massive purchases of private debt and issued hundreds of billions of dollars in short-term loans. The result was a doubling of the size of the monetary base in the final four months of 2008. This article discusses the details of the programs that the Fed has initiated since the crisis began, shows which programs have grown as the monetary base grew, and discusses some factors that will determine whether this rapid increase in the monetary base will lead to rapid inflation.


A logical question might be why depository institutions would choose to hold $800 billion in excess reserves that are earning so little. Two answers are important, one at the level of the individual bank and one at an aggregate level.

Update: Steven Keen and cross posted at Naked Capitalism does yoeman’s work on the issues.

First, for the individual bank, the risk-free rate of ¼ percent must be the bank’s perception of its bestinvestment opportunity. Note that on January 28, 2009, the interest rate on the 3-month Treasury bill was less than ¼ percent. The other is that,perhaps because of market conditions—the dramatic decline in the price of bank stocks and the fall in the market value of assets—the bank finds itself undercapitalized. In such conditions, the bank is likely to hold relatively more safe assets while it builds capital by cutting costs, raising fee income, and hoping for a recovery in both the economy and its stock price.

Second, the banking system as a whole cannot create or destroy bank deposits at the Fed. Only the Fed (and technically, the Treasury) can create or destroy bank reserves. If one bank makes a loan and the funds are deposited in another bank, then the ownership of the deposits at the Fed would change, but the total bank deposits at the Fed would remain the same. In theory, the banking system reduces excess reserves—but only by expanding loans and the money supply in a way that increases required reserves by an equivalent amount.

The key is that the Fed will have to drain reserves when the economy begins to recover if it is to prevent a rapid acceleration of inflation. That necessity drives the current discussion of exit strategies.8 The ease with which the Fed can reduce the size of its balance sheet in the future depends on many factors, including the term of its loan portfolio, the quality of assets that it holds outright, and the market’s appetite for repurchasing these financial instruments. The authorization for the ultimate size of new programs varies and has grown since the beginning of the crisis. Table 2 lists each new program and the upper limit authorized as of January 28, 2009. Of course, in some cases the limits will be determined by the available assets and/or by the demand for the program. (Note that there are zero assets in the MMIFF, which has an authorization of $540 billion.)

When the time comes to shrink the monetary base, the Fed could allow the lending programs to expire as loans mature and sell the assets that it holds outright. If the crisis is over, the assets should be priced in the market and the Fed should
expect to recover most of its investment in such assets.

Inflation does not appear to be a risk in the current environment: The economy is in recession. Inflation is falling and is not expected to return before the recession ends. If inflation resumes but the economy does not recover, policymakers will face a difficult choice. Monitoring the size and composition of the monetary base as the economy recovers will help us understand what actions are needed (and should be taken)by the Fed and the Congress to prevent a return of high inflation.

Reuters points to a key concern:

“Inflation does not appear to be a risk in the current environment: the economy is in recession. Inflation is falling and is not expected to return before the recession ends,” according to an essay in the March/April edition of Review magazine, published by the Federal Reserve Bank of St. Louis.

“If inflation resumes but the economy does not recover, policy-makers will face a difficult choice. Monitoring the size and composition of the monetary base will help us understand what actions are needed,” the study said.

Emergency measures to flood credit markets with cash to stop them freezing in panic over bank losses doubled the size of the Fed’s balance sheet and boosted the monetary base to around $1.7 trillion.

Fed officials agree they need an exit strategy to soak this money back up once the recession ends. They don’t think it is an inflation risk right now because banks are still too scared to lend the extra money out in a way that would boost the broader money supply and lead to higher prices.