The Non-Relationship Between Interest Rates and the Money Supply

by Mike Kimel

This piece has been cross-posted at The Presimetrics Blog.

The Non-Relationship Between Interest Rates and the Money Supply

Figure 1

The graph shows that all but one recession since 1948 was preceded by a big drop in the real money supply per person over the length of a year. The exception – July of 1953 – wasn’t much of an exception; the 12 month change in the real money stock per capita went negative in August of 1953 and remained negative throughout the length of that recession.

Now, I use real M1 per capita a lot in my posts; I think it’s a largely unused but very good (in part because it is largely unused) measure of monetary policy, and its one Michael Kanell and I use in Presimetrics. For instance, we discuss how it affects economic growth, and we look at how much real M1 per capita increased over the length of each administration. (Note – the change in real M1 per capita, like other measures of monetary policy, is under the control of the Federal Reserve, not the executive branch.)

But because it isn’t used much, every time I do use it, I find there is a bit of confusion. And because it is so useful, I think it is worth spending a bit of time covering it.

I’d like to start with a question I get asked a lot, which will be the topic of this post: what sense does it make to use real M1 per capita (or any other measure of the money supply) as a way to monitor the Fed’s monetary policy? After all, what the Fed does is set interest rates, or rather, one interest rate in particular: the Federal Funds rate. And when it does that, the money supply gets set by default. A fair number of college seniors majoring in econ, when pressed, could probably tell you a story like this:

The Fed determines what the Federal Funds interest rate should be. If the Fed wants to reduce interest rates, it will create money out of thin air and use it to buy bonds. Because there is more money competing to buy bonds, the interest rate bonds have to pay falls. At the same time, the added money sloshing around becomes cheaper for anyone to borrow, whether they’re issuing bonds or not. On the flip side, if the Fed wants to raise interest rates, it sells bonds. That forces anyone else trying to sell bonds to raise interest rates to compete. Additionally, because the Fed retires the money it gets paid for the bonds it sells, that process reduces the amount of money available in the economy, making it harder to come by and hence more costly.

It’s a nice story, and like many others that is taught in economics classes across the country, it works fine in theory. It may even apply in a lot of real world situations. As I will show below, however, it doesn’t have much if anything to do with the way the U.S. economy operates.

Now, I’ve got a lot of ground to cover today, and being charge of watching the newborn while the wife is out and about, I don’t have a whole heck of a lot of time, so whereas I’d normally be throwing up a lot of graphs to show what I mean, instead I’m going to tell a little story and then show you that the folks responsible for setting the money supply agree with the story.

Here’s the story: Americans like to shop, and they seem to really like to shop in December. (Apologies for the lack of a graph, but you can find one example of the data here.) Shopping is easier when there’s more liquidity in the system – that is to say, when money is looser and easier to come by – so the Fed should be expected to loosen the real money supply somewhat to accommodate the end –of-year shopping season. On the other hand, as anyone who watches the news can tell you, the Fed doesn’t exactly move interest rates around in a way that would suggest any loosening around December each year with a subsequent tightening up early in the next year. Which means either: a) the Fed does nothing to accommodate the end –of-year shopping season or b) the money supply and the interest rates, at least within some not-so-narrow range, have very little to do with each other.

Now, if the Fed is trying to loosen the money spigot to help the shopping season along every year, it isn’t doing it with interest rates. Interest rates don’t seem to display much of a pattern when it comes to the calendar. You don’t hear anyone say, “I’m waiting until to December to refinance the house since rates are always lower then.”

What about real M1 per capita? Well, there we see a pattern. Using data from January of 1948 to December of 2008, we can construct 721 blocks made up of 12 consecutive months. The first of these blocks runs from January of 1948 to December of 1948, the second from February of 1948 to January of 1948, and so forth, until January of 2008 through December of 2008.

The graph below shows the percentage of these blocks in which each month had the highest real M1 per capita. For example, the percent of blocks for which the peak real M1 per capita for the block occurred in January is shown in the first bar, the percent of blocks for which the peak real M1 per capita for the block occurred in February is shown in the second bar, etc. So look what happens:

Figure 2.

Clearly, by far, the real money supply per capita is looser in December than any other month, and by a degree well outside the range that anything resembling chance would support. The fact that January comes in second is probably a function of spillover from December – the Fed doesn’t always drain out the money supply as quickly as it might otherwise like.

So… to sum up what we have… the Fed has a reason to loosen the money supply in December. Interest rates don’t show any pattern that works with the Fed’s goals, but real M1 per capita does. This indicates that unless there’s some really big coincidence going on, interest rates and real M1 per capita do not move together and the Fed is/seems to be using real M1 per capita (or something very similar) to accomplish many of its liquidity goals.

While I tend to let data speak for itself, I’d like share a couple of quotes. Here’s the first

Because of these difficulties in achieving a subtle response of the Federal funds rate to changes in the amount of borrowing, achieving the degree of reserve pressures specified in the directive has been interpreted since the late 1980s to mean creating conditions consistent with the FOMC’s desired Federal funds rate. That rate has generally been apparent to the banks; since 1994 it has been announced formally and in prior years it was clearly indicated through an open market operation. The rate has tended to move to the new, preferred level as soon as the banks knew the intended rate, with little or no change in the amount of borrowing allowed for when constructing the path for nonborrowed reserves (described below).

I bolded a key sentence in the above paragraph; it indicates that the Federal funds rate is set not by the buying and selling of bonds, as textbooks will tell us, but rather by the Fed’s wish. Since 1994, the Fed has announced its target rate, and the rate starts moving in that direction immediately upon the announcement, not waiting for open market operations. Prior to 1994, the target rate wasn’t announced, but banks tried to get figure out that target through statements made by Fed officials and head to that rate anyhow.

A second quote from the same source:

A prominent seasonal factor affecting deposits is the buildup in balances to accommodate the extra transactions during the holiday period, stretching from late November to early January (and the sharp reversal during January). A shorter term seasonal pattern arises from the payment of social security benefits on the third of each month; most recipients allow their cash balances to rise initially, then gradually work down the deposits as they pay their bills. (The Treasury’s total cash position might show offsetting movements, but most Treasury cash is not subject to reserve requirements.3)

This quote indicates that the Fed does, indeed, try to accommodate additional seasonal liquidity (including those in December I noted in Figure 2).

So, these quotes match the data I described and support my conclusion. Which is to say, I’ve found another heathen who refuses to accept the standard textbook monetary policy story about how the money supply and interest rates behave. So where do these quotes come from, you ask?

You’ll find the quotes I cited on pp. 141 – 142 and p. 142, respectively, of the chapter on Open Market Operations in a textbook on monetary policy produced by the New York Fed. That is to say – the people directly responsible for the buying and selling of bonds on behalf of the Federal Reserve aren’t don’t seem to feel that their activities have anything to do with the setting of interest rates. But what does it say about the economics profession that the rest of us are under the misimpression that it does?

I’ll have at least one more post soon on real M1 per capita and its effect on the economy.

Data Sources

FRED, the Federal Reserve Database, was the source for most of the data used to compute real M1 per capita: population from 1952 to the present , M1 from 1958 on and M1 from 1958 on.

Quarterly data on real GDP per capita and population. Note – the quarterly population figures were used to extrapolate monthly population for 1947 to 1952.

Finally, money stock figures were substituted in for M1 from 1947 to 1957. Those were copied by hand from this document at the