Since 2007 the Federal Reserve has nearly tripled the size of its portfolio of securities. Fed officials say their action has produced a highly accommodative policy. However, recent signs point to a dramatic slowdown in spending. This has raised concerns over future monetary options. If monetary policy is already highly accommodative, what further action can the Fed take?
Milton Friedman’s main contribution to monetary analysis was to highlight the relationship between the creation of money and subsequent changes in spending. If the near tripling in the size of the Fed’s portfolio since 2007 signals a highly accommodative policy, then the subsequent weakness in current dollar spending means that Friedman’s main contribution to monetary policy has to be rejected on empirical grounds.
Before dismissing Friedman’s analysis, it’s important to consider another explanation for the recent slowdown in spending. The alternative explanation is that monetary policy has not been nearly as expansive as most people seem to think.
This explanation suggests that neither interest rates nor the size of the Fed’s portfolio are necessarily valid policy indicators. Instead, it suggests that monetary stimulus should be measured by the amount of bank reserves that are used to support bank deposits.
To arrive at such a measure, it’s important to remove deposits that banks choose to keep with the Federal Reserve, namely excess reserves. While these deposits can potentially be used to support loans and investments, as long as they are kept at the Fed they are not able to do so.
When reserves do not support loans and investments in the banking system, they are not able to support bank deposits or add to the money supply. When money is measured correctly, it turns out that Friedman’s analysis of monetary policy is every bit as relevant today as it has been at any time in history.
The Federal Reserve Bank of St. Louis produces data on bank reserves adjusted for reserve requirements. Subtracting excess reserves from this measure shows that in the six months ending in August, 2008 the amount of bank reserves supporting bank deposits had fallen to $93 billion. This was down from $95 billion in early 2005.
The Fed’s shift from aggressively supporting bank reserves prior to 2005 to actually reducing those reserves represents the most dramatic shift in monetary policy since the early 1930s. The collapse in spending that followed this shift (now referred to as the Great Recession), is fully consistent with Friedman’s monetary analysis.
In the six months ending in April 2009, the same monetary measure totaled $106 billion, an increase of 13%. Within the 6-9 month lag that Friedman’s analysis allows for, the pace of spending improved and the economic recovery began.
By last December, the comparable figure was essentially unchanged at $107 billion. In August of this year, the 6-month average was still $106 billion. The lack of growth in this measure of money is fully consistent with both the weak pace of spending as well as the recent weakness in stock prices.
There is widespread agreement among monetary economists that the Federal Reserve has complete control of the amount of bank reserves. By ignoring this crucial monetary measure, Fed policymakers produced the most dramatic period of monetary restraint since the early 1930s. That restraint was followed by the most dramatic slowdown in spending since the 1930s.
Recently, Fed members have again chosen to ignore the behavior of bank reserves. The result has been a lack of growth in this key monetary measure. As in the past, this lack of growth has led to a sluggish pace of spending.
To restore a faster pace of spending, the Fed should monitor the supply of bank reserves used to support bank deposits. Moderate growth in the amount of bank reserves available for loans and investments would work its way through financial markets and into the economy. Allowing for the typical lag, the pace of spending would then respond to the increase in money much as Friedman’s analysis has shown it has done throughout history.
Robert Genetski ([email protected]) is a Heartland Institute policy adviser and runs classicalprinciples.com, which provides financial guidance using classical economic and investment principles. Used with permission.