In its September Monetary Trends letter titled “The Monetary Base and Bank Lending: You Can Lead a Horse to Water…” the St Louis Fed analyzes the phenomenon that has all monetarists up in arms, namely the surge in the monetary base and the very muted increase (and outright alleged drop in the case of the M3) of monetary stock, going back to the core topic at every debate over hyperinflation/deflation: the money multiplier, and its current reading of well below 1. What is the reason for this discrepancy: as the St Louis Fed explains: “The answer centers on the willingness of depository institutions (banks) to lend and the perceived creditworthiness of potential borrowers. A deposit is created when a bank makes a loan. Ordinarily, bank loans—and hence deposits—increase when the Fed adds reserves to the banking system. How ever, despite an increase in reserves of over $1 trillion, total commercial bank loans were some $200 billion lower in May 2010 than in September 2008. Banks added to their holdings of securities, which resulted in a modest increase in deposits and the money stock, but many banks were reluctant to make new loans.”
And herein lies the rub: if and when the economy ever picks up, and at this point that looks like an event that may well never happen, “Many economists worry that bank lending and monetary growth will eventually surge and, ultimately, cause higher inflation.” The backstops offered by the Fed looks increasingly more brittle: reverse repos and IOER. The longer ZIRP continues, the more aggressive the Fed will have to become if and when the money multiplier finally shoots higher. If prior examples of hyperinflation are any indication, this will not be a seamless or smooth process, which is why aside from the traditional calls for hyperinflation as a result of a collapse in the faith of the monetary system as a whole, many are also calling for this outcome should the Fed, paradoxically, stabilize the economy. And it is about to get worse: the Fed’s balance sheet is likely about to grow by another $2 trillion as soon as QE 2 is announced. Which means that by the time the economy needs to remove excess liquidity, the Fed will need to find a way to remove not $2Bn, but probably double that number. The simple conclusion is that the longer the Fed fights deflation, the greater the likelihood for (hyper) inflation as the final outcome once it ultimately rights the economy. We tend to think that Odysseus was faced with an easier choice.
From the St. Louis Fed:
In its response to the worsening financial crisis during the fall of 2008, the Federal Reserve took actions that dramatically increased the size of the monetary base (the sum of currency in circulation and depository institution deposits with the Fed) (see chart). Subsequently, the Fed purchased some $1.7 trillion of securities issued by the U.S. Treasury and federally sponsored housing agencies, which expanded the monetary base further. The base more than doubled in size between September 2008 and May 2010. Yet measures of the money stock, such as MZM, M1, and M2, increased far less. For example, M1 increased about 17 percent over these months; consequently, the ratio of M1 to the monetary base (measured by the St. Louis Adjusted Monetary Base), commonly referred to as the “M1 money multiplier,” fell from about 1.6 to 0.84.
Why was the increase in the money stock so small when the increase in the monetary base was so large? The answer centers on the willingness of depository institutions (banks) to lend and the perceived creditworthiness of potential borrowers. A deposit is created when a bank makes a loan. Ordi –
narily, bank loans—and hence deposits—increase when the Fed adds reserves to the banking system. How ever, despite an increase in reserves of
over $1 trillion, total commercial bank loans were some $200 billion lower in May 2010 than in September 2008. Banks added to their holdings of securities, which resulted in a modest increase in deposits and the money stock, but many banks were reluctant to make new loans. Partly this reflected weak loan demand, but it also indicated a diminished appetite for risk on the part of bankers. Further, a lack of equity capital (and a high cost of obtaining additional capital) constrained the lending of many banks (banks are subject to minimum capital requirements based on their outstanding loans and other assets).
Many economists worry that bank lending and monetary growth will eventually surge and, ultimately, cause higher inflation. Minutes of Federal Open Market Committee meetings indicate that Fed officials have discussed possible measures to discourage excessive growth in lending and the money stock. One option is to sell securities outright or under repurchase agreements, which would shrink the monetary base. Recent experience illustrates, however, that large changes in the base may be necessary to effect the desired changes in bank lending. Another option is to raise the interest rate paid to banks on their reserve deposits, which would raise the opportunity cost of lending and thereby tend to exert upward pressure on market rates generally and slow the growth of loans and the money stock. However, because the Fed has little experience with paying interest on reserves,
it is difficult to predict how much bank loans would change in response to an increase in the interest rate paid on reserve deposits. Hence, the Fed may resort to both options if monetary growth threatens to become excessive.
—David C. Wheelock