There is zero correlation between the Fed printing and the money supply. Deal with it.

There is zero correlation between the Fed printing and the money supply. If you don’t believe this, you owe it to yourself to study up on monetary policy until you do.

This is an issue that brings them out of the bunker like no other in economics. But if you are an investor, trader or economist, understanding—and I mean really understanding, not just recycling things you overheard on a trading desk or recall from econ 101—the mechanics of monetary policy should be at the top of your checklist. With the US, Japan, the UK and maybe soon Europe all with their pedals to the monetary metal, more hinges on understanding this now than ever before.

And, as we saw this week, even many of the Titans of finance and economics have it wrong.

“Wrong? You’re saying they’re wrong? They have tons of money. They have long track records. I mean, they’ve seen it all.  How can you say that? That’s just arrogant.  Besides, did I mention they have tons of money?”

Here’s why the Titans are wrong

Brad DeLong had an entertaining piece on whales, super whales and men who hate the Fed, but the answer is much simpler than the one he offers. In fact, if you’ve ever been in the belly of a hedge fund, you know the answer to most everything is much simpler than it appears to the mere mortals on the outside.

The bottom line is the titans are working from the wrong playbook. We’re all, to varying degrees, slaves to our experiences. Their formative experiences, almost to a man, were in the early 80s. This is when they built their knowledge and assembled their financial playbooks. They learned words like Milton Freidman, money multiplier, Paul Volcker, Ronald Reagan, and the superneutrality of money. Above all, they internalized one dictum: real men have hard money.

This understanding implies that an increase in bank reserves deposited at the Fed (i.e. “printing”) eventually feeds credit growth and thereby inflationary pressures; in other words, no base money increase, no credit growth. Only one problem: reality disagrees.

Here are the facts

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.

How is that possible? I thought in a fractional reserve system base money had to grow for credit to expand?

The answer is structural. The financial deregulation that began in the early 80s (significantly, the abolition of regulation Q) and the consequent development of repo markets fundamentally changed the transmission mechanism of monetary policy. Collateral lending is now king. Today, length of collateral chains and haircut rates—neither of which are determined by the Fed—define the upper bounds of the money supply, not base money and reserve requirements.

What about the relationship to inflation? Isn’t base money correlated to that? Here’s a graph, from this piece by central banking expert Peter Stella.


The X axis shows 5-yr growth rate of base money (loosely defined) and the Y axis shows annual yoy inflation. That’s right. Nobody home here, either.

Don’t confuse liquidity with credit

The Federal Reserve only provides liquidity. The amount of liquidity it puts in the reserve system has no direct impact on the issuance of credit by banks or shadow banks. Only banks and shadow banks can create credit. And they lend either out of cash on hand or by repo-ing treasuries, mortgages, or deposits, if cash on hand is insufficient. And collateral that is pledged once can be pledged over and over and over (collateral chain). So, even though credit increases, the total amount of banking reserves on deposit at the Fed remains unchanged (though composition across banks may change).

So if the banks and shadow banks can just as easily repo their Treasury and mortgage holdings to finance lending, and there is no link between base money and credit creation, why is the Fed doing QE in the first place?

By keeping rates low well out the yield curve and providing comfort that the Fed will be there to fight the risk of recession and deflation, it creates an environment that enables, over time, a normalization of risk taking in the real economy. Our revealed belief is that the Fed can chop these nastier outcomes off the left-hand side of the distribution. As a result we start feeling better about putting our getting our money back out of the mattress and putting it back to work.

Risk taking always starts in financial markets, but eventually bleeds it way into the real economy. And, if you listen carefully, you can hear over the pitched squeals of fixed income investors, who are suffering from sticker shock and low yields, that this is exactly what’s transpiring. The time bought with aggressive monetary policy is allowing household balance sheets to the labor market to slowly heal. Heck, even the fiscal position is rapidly improving.

Again, it is important to underscore that it is the indirect psychological effects from Fed support and the low cost of capital—not the popularly imagined injection of Fed liquidity into stock markets—that have gotten investors to mobilize their idle cash from money market accounts, increase margin, and take financial risk. It is our money, not the Fed’s, that’s driving this rally. Ironically, if we all understood monetary policy better, the Fed’s policies would be working far less well. Thank God for small favors.

This is not a semantic point. I can hear traders saying “yeah, whatever, who cares, don’t fight the Fed, just buy”. But this concept has huge implications for the phase where the Fed decides to remove the training wheels. If the Fed money is not directly propping up the stock market and the economy underneath has been healing, the much talked about wedge between “Fed-induced valuations” and “the fundamentals” is likely considerably smaller than the consensus seems to think. It’s less “artificial”. In short, what all this means is the day the Fed lets up off the gas might give us a blip, or maybe that long-awaited correction, but ultimately the Policy Bears will end up getting crushed, again.

The other, more mechanical, implication is that financial sector lending is neither nourished nor constrained by base money growth. The truth is the Fed’s monetary policy can influence only the price at which lending transacts. The main determinant of credit growth, therefore, really just boils down to risk appetite: whether banks and shadow banks want to lend and whether others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share?

These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around–in large part because of what Econ 101 misguidedly taught us about the primacy of price, incentives and rational behavior. If you answer the behavioral questions and ignore the endless misinformation about base money—even when it’s coming from the titans of finance—as an investor you’ll be much better off.

13 Replies to “There is zero correlation between the Fed printing and the money supply. Deal with it.”

  1. The only rational behavior that is truly dependable is when given a choice between monetary discipline and juicing the economy, by whatever means, nobody picks monetary discipline.

    1. What constitutes ‘monetary discipline” is subjective. And unfortunately, many are still trying to define what that means by looking in the rear view mirror. I think the best guide to what makes sense wrt monetary policy is looking at how well the Fed is fulfilling its mandate. And on that score–whatever your subjective view of equity valuations is telling you–the Fed has been very disciplined and pragmatic

  2. “There is zero correlation between the Fed printing and the money supply.”

    Is that really so? Really?

    Does that match experience?

    The graph shown shows rates of growth on the x and y axis, not levels. Have you graphed the levels? Please, try that and post it.

    The graph given says nothing of the levels. If you graph the levels it will match experience. The money level and price levels are correlated over the long term.

    Even if you do not graph the levels; look at where the points are, please. They are mostly in the first and second quadrant of the graph you gave. What does that mean?

    If you drew axis at x=2 and y=4 where are those growth points. Most points would be in the first and third quadrants. But not in a line. What would that mean?

    A graph of changes accentuates the quick movements and not the longer steady movements. And, a graph of levels shows longer term dynamics.

    1. You can’t use levels when dealing with non-stationary time series–unless of course you use cointegration techniques to effectively de-trend them. Otherwise you get spurrious correlations.

  3. This piece on vectors illustrates some of the reasoning behind what the data shown in the blogs graph and the ones I have linked to above.

    Basically, economists should also look at levels, not just throw them away.

  4. RE: Graph of Changes above (are akin to displacements from the origen)

    If you took a step in the y direction only (North) and then later took a step in the x direction only (East) and repeated you would net move in a diagonal direction. The net x movement would correlate with the net y movement. You would have moved North East.

    Or, the level of x would correlate with the level of y.

    Both the CPI level and the amount (level) of reserves at the central bank (money)
    have increased over time.

  5. Any half-way decent principles text will tell its readers that the growth rate of quantity of base money is but one of several determinants of broad money growth rates, the other being the real demand for bank reserves; and any such text will also point out that broad money growth in turn is but one of two mutually exhaustive determinants (the other being the velocity of money) of an economy’s inflation rate.

    The same textbooks are also likely to point out the many policy and environmental developments that led to substantial changes in both the real demand for bank reserves and the velocity of broad money starting in the early 80s, if not before: rising inflation rates; the appearance of money-market mutual funds; the eventual deregulation of rates on bank deposits; and changes in both the structure and the manner of enforcing of minimum bank reserve requirements, are just the most obvious of these.

    For all these reasons the claim that growth in bank reserves leads to corresponding growth in money and prices is properly understood, and has been understood by all competent economists, as a comparative-statics proposition. Just as importantly, all the divergences of measured inflation from the rate of reserve growth are perfectly consistent with this comparative-static proposition, once one allows for other such propositions pertaining to the determinants of velocity and the multiplier. So there’s absolutely nothing mysterious about the data pointed out here. (On the other hand, it is very easy to show despite everything said above that broad money growth rates and inflation have been very much positively correlated, both in the U.S. across time, and across countries, for the 1960s-2000s taken as a whole.)

    What purports here to be a demolition of Econ 101 is, in short, actually nothing more than a demonstration of the fact that the author may wish to consider enrolling in that class one more time!

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