Why the Monetary Base is Irrelevant
I received an objection to my previous post from a commentator who argued that since the monetary base in America had grown only slowly, monetary conditions really are tight. Caroline Baum argued the same in her latest Bloomberg column:
"A fire can't burn without tinder; inflation can't smolder when the Fed is creating the raw material at a snail's pace. The monetary base, which consists of bank reserves and currency, is growing at an anemic 1.1 percent rate. In inflation-adjusted terms, the base is contracting."
Yet if the commercial banks are creating it at an extremely rapid rate, inflation can take hold. As I pointed out in my previous post, bank lending has increased 6.5% (17% at an annual rate) since early August and MZM money supply has increased nearly as fast , 6.3% (16.4% at annual rate).
And what matters for the economy is total money supply and not the monetary base. A good example of this is provided by the time period of 1921-33. During 1921-29, the monetary base was nearly unchanged, yet we saw rapid growth and a stock market bubble. By contrast, the monetary base grew very fast in 1930-33, yet that was combined with a deflationary depression and a 90% decline in stock prices.
The reason for this is that despite the stagnant monetary base, money supply growth was fast during the 1920s. And despite the soaring monetary base, money supply fell sharply during the depression.
The monetary base is not a reflection so much of Fed policy, but demand for cash. And by cash I mean notes and coins. It is not certain why demand for cash seem to be falling. It could reflect a continued shift away from paper money to electronic money in economic transactions in America. Or, it could reflect falling global demand for U.S. Federal Reserve notes as trust in the dollar declines. In the past hundreds of billions of dollars in Federal Reserve notes have been exported to countries like Russia and many Latin American countries with high inflation as people there trusted the dollar more than their local currency. But as many of those countries have seen a decline in their previously high inflation, and as the euro to many seems like a better currency than the U.S. dollar, Federal Reserve notes are probably increasingly returning to the United States.
"A fire can't burn without tinder; inflation can't smolder when the Fed is creating the raw material at a snail's pace. The monetary base, which consists of bank reserves and currency, is growing at an anemic 1.1 percent rate. In inflation-adjusted terms, the base is contracting."
Yet if the commercial banks are creating it at an extremely rapid rate, inflation can take hold. As I pointed out in my previous post, bank lending has increased 6.5% (17% at an annual rate) since early August and MZM money supply has increased nearly as fast , 6.3% (16.4% at annual rate).
And what matters for the economy is total money supply and not the monetary base. A good example of this is provided by the time period of 1921-33. During 1921-29, the monetary base was nearly unchanged, yet we saw rapid growth and a stock market bubble. By contrast, the monetary base grew very fast in 1930-33, yet that was combined with a deflationary depression and a 90% decline in stock prices.
The reason for this is that despite the stagnant monetary base, money supply growth was fast during the 1920s. And despite the soaring monetary base, money supply fell sharply during the depression.
The monetary base is not a reflection so much of Fed policy, but demand for cash. And by cash I mean notes and coins. It is not certain why demand for cash seem to be falling. It could reflect a continued shift away from paper money to electronic money in economic transactions in America. Or, it could reflect falling global demand for U.S. Federal Reserve notes as trust in the dollar declines. In the past hundreds of billions of dollars in Federal Reserve notes have been exported to countries like Russia and many Latin American countries with high inflation as people there trusted the dollar more than their local currency. But as many of those countries have seen a decline in their previously high inflation, and as the euro to many seems like a better currency than the U.S. dollar, Federal Reserve notes are probably increasingly returning to the United States.
posted by stefankarlsson at 1:46 PM
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