Hasn't the Fed been creating money out of thin air and won't that lead to high inflation? You hear that from politicians as well as on the comedy channel. But is it true? Not quite. When the Fed purchases securities, it credits the accounts that banks have at the Fed, increasing bank reserves (but not creating any new money). Before these new reserves can affect inflation, they first must enter the economy in the form of loans and then be spent on goods and services. Let's look at this in more detail (note: it may be helpful to read the section on monetary policy during the financial crisis together with this one to understand the unique behavior of the monetary system during and since the Great Recession).
Since the Fed began to respond to the financial crisis by increasing its balance sheet, there has been concern expressed by some about how this could adversely affect the economy in terms of high inflation. Before we proceed, we need to provide some background. First, what do we mean by the Fed's balance sheet? A balance sheet contains assets and liabilities. When people refer to increases in the Fed's balance sheet, they're referring to the increase in the assets held by the Fed, which tends to include securities and loans that it has made. Prior to the crisis, the Fed's assets totaled about $800 billion but rose to about $2 trillion as of December 2010. How did this happen? The Fed purchased over $1 trillion worth of mortgage-backed securities as well as a large amount of Treasury securities in its effort to contain the effects of the financial crisis. Since assets equals liabilities (recall from accounting), when the Fed's assets rose, it's liabilities rose by an equivalent amount. Its primary liabilities include currency plus bank reserves, which together form the monetary base.
Reserves
Reserves are the amount of funds that banks hold, whether in their vault or at their account at the Fed. Banks must hold a portion of certain deposits as reserves, known as required reserves. Any reserves beyond what's required are called excess reserves. As the Fed purchased securities, bank reserves tended to rise by a similar amount. Why? An easy way to see this is to consider what happens when the Fed buys a security from a bank (though purchases from investors other than banks have similar effects). In this case, the Fed acquires the security and the bank's account at the Fed is credited by the amount of the purchase (how much? it depends on the market price of the security). Since the banks have more funds but deposits haven't changed (so there's no change in required reserves), the increase in reserves involve excess reserves.
Traditionally, banks held very little excess reserves. Why? Banks earn revenue primarily by being paid interest on loans. Any funds held as reserves would take away from potential earnings. The main reasons to hold excess reserves would be if the bank is concerned that many customers may withdraw funds at the same time (a bank run) or if banks incur or are afraid that they may incur large loans losses. As the financial crisis began in the summer of 2007, excess reserves rose to $2 billion.
Why Did Banks Increase their Holdings of Excess Reserves?
Beginning in Fall 2008, excess reserves soared to over $1 trillion. Almost all of the Fed's purchases of securities in response to the financial crisis resulted in increased excess reserves - i.e., banks just held onto the funds. Why? Most economists think the main reason was that banks had incurred massive losses on mortgages and related assets (with fears of more to come) and feared large losses on other loans such as commercial real estate. Some economists also think the Fed's new ability to pay interest on reserves played a role. Many central banks around the world had been paying interest on reserves for a long time. However, the Fed was first given the authority to do so beginning on October 1, 2008. The Fed sought this authority so as to better be able to conduct monetary policy, particularly the management of excess reserves. It knew that banks were building up a huge amount of excess reserves that could pour into the economy at some point in the future. By paying interest on reserves, it hoped to be able to manage the flow of these reserves (if excess reserves started to pour into the economy, it could limit the flow by increasing the interest on reserves to make it more attractive for banks to hold excess reserves). How much interest does the Fed currently pay on excess reserves? It set it at the same rate as its target for the federal funds rate, 0.25%. This provides banks some incentive to hold onto excess reserves. However, it seems unlikely that banks would increase excess reserves from $2 billion to over $1 trillion just to earn 0.25% interest. Also, excess reserves began to rise significantly prior to the Fed beginning to pay interest on reserves. So though interest on reserves may play some role, it's likely that the primary reason banks increased their excess reserves was due to large loan losses and caution about the financial system.
But didn't the Fed increase excess reserves by purchasing securities? The Fed increased the funds available to banks through it's purchases, but banks chose to hold onto the reserves. They could have taken the funds and lent them out, but instead thought it was preferable to increase their holdings of reserves. Given that it was the choice of banks to increase their reserves, it's likely they would have done so even if the Fed didn't purchase securities. How would they have done this? Through drastic reductions in lending (hold onto deposits, ending lines of credit, etc.). This is one of the most misunderstood aspects of the impact of monetary policy as well as key difficulties in assessing the likely impact of policy. When critics claim that the Fed is printing money and letting the money supply get out of control, they're missing a key point, at least for now. Recall that the money supply includes currency plus deposits while the monetary base is currency plus reserves. The monetary base exploded in recent years, but growth in the money supply has been limited. Does this mean that the Fed's actions will not affect the money supply?
The Money Multiplier: Connecting Changes in the Monetary Base to Changes in the Money Supply
We briefly discussed the relationship between the monetary base and the money supply. Under normal conditions, if banks have more excess reserves, they will loan them out to earn higher interest. These loans are used to purchase houses, cars, appliances, etc. Car dealers, stores, developers, etc., will take the funds and put them in their bank accounts (deposit the check), leading to an increase in the money supply. As banks gain more deposits, they will be able to make more loans and the process repeats itself, leading to further increases in lending, spending and bank deposits. The relationship between the initial amount of excess reserves and subsequent increase in bank deposits is known as the money multiplier process. Recall that the initial increase in reserves leads to an increase in the monetary base while the subsequent increase in deposits leads to an increase in the money supply; thus increases in the monetary base normally lead to an increase in the money supply. The money multiplier measures this relationship. For example, suppose excess reserves increase by $2 billion (thus the monetary base rises by $2 billion), which are lent, eventually resulting in a $10 billion increase in deposits (thus the money supply rises by $10 billion). In this case, the money multiplier is 5 ($10b/$2b). Though the money multiplier can change, normally it doesn't change by much. What if normal conditions do not hold? In late 2008, banks began to hold significantly more reserves, thus funds did not circulate throughout the economy. Since the increase in reserves were not being lent, they did not result in new deposits, thus the money supply did not respond to the increase in reserves. As seen elsewhere, the money multiplier collapsed; the M1 multiplier declined from about 1.6 to 0.8 while the M2 multiplier declined from about 9 to just over 4. What impact could this have had on the money supply? If the monetary base had not changed, the money supply would have declined at the same rate as the money multiplier (about 50%). When was the last time the money supply collapsed that much? The last time the money supply experienced a dramatic decline was in the early 1930s, resulting in the Great Depression. To quote Milton Friedman (1975 Nobel Prize winner for his research on monetary policy) in reference to Fed policy at the beginning of the Great Depression, "Had the money stock been kept from declining, as it clearly could and should have been, the contraction would have been both shorter and far milder. It might still have been relatively severe by historical standards... I know of no severe depression in any country or any time that was not accompanied by a sharp decline in the stock of money and equally of no sharp decline in the stock of money that was not accompanied by a severe depression." To prevent a collapse in the money supply and the economy, the Fed increased the monetary base enough to offset the decline in the money multiplier. Thus, though the monetary base rose from about $800 billion to $2 trillion, the money supply didn't increase by much.
The Velocity of Money: How the Money Supply Affects Inflation and Economic Growth
Suppose that the money supply did increase significantly - would that be inflationary? Not necessarily. Recall that it is sometimes said that 'inflation occurs when too much money chases too few goods.' If there is no chase, than there would be no inflation. Economists use the term velocity to refer to this chase. The velocity of money (V) is the average number of times a dollar is used in transactions in a given year and is estimated by dividing nominal GDP (PY, which is the price index x real GDP and represents the dollar value of transactions in the economy) by the money supply (M; the number of dollars). This can be rearranged to obtain the following relationship, MV = PY. In other words, the amount of money multiplied by the average number of times money is used in transaction results in nominal GDP; note that this must hold true since it's based on a definition (definition of velocity), not a theory. Normally, velocity doesn't change by much and thus changes in the money supply have an effect on the price index and/or real GDP (inflation and economic growth). However, velocity experienced a significant decline during the financial crisis. Prior to the Great Recession, the velocity of M2 was about 1.9, but fell to about 1.6, a decline of more than 15%. If the money supply doesn't change and velocity declines by 15%, nominal GDP declines by 15%, meaning that some combination of the price level (inflation) and real GDP (economic growth) would decline by 15%. Thus, if velocity is declining, the money supply should be increased to prevent a fall in nominal GDP (thus stabilizing inflation and economic growth).
How Does the Fed's Balance Sheet Affect Inflation and Economic Growth?
Now we can take a step back and look at the big picture, the relationship between the Fed's balance sheet and the economy. Under normal conditions, Fed purchases of securities lead to an increase in the monetary base and the money supply which then affects inflation and economic growth. However, in the unique environment experienced recently, both the money multiplier and velocity of money declined significantly. As a result, the rapid increase in the Fed's balance sheet did not have a significant impact on the money supply (due to the collapse in the money multiplier). Though the money supply did increase somewhat, it didn't have a significant effect on inflation and economic growth due to the significant decline in the velocity of money. If the Fed hadn't taken extraordinary actions, the money supply would have plummeted and the economy would likely have experienced a depression. How can we make such a claim? The reasoning described above (which doesn't involve any theories) makes it clear. Also, historical experience verifies that this is the case. For example, the Fed was passive in response to the financial crisis of the early 1930s. As the money multiplier collapsed, the Fed did not increase the monetary base by much, resulting in a large drop in the money supply followed by deflation and the Great Depression. Most economists, led by the research of Milton Friedman, think that if the Fed engaged in quantitative easing in the early 1930s, we could have avoided the depression. Fortunately, the lesson was learned and applied in 2008. However, given the risks involved, most economists think quantitative easing should only be used in extreme circumstances.
The Fed's Exit Strategy
What happens as conditions begin to return to normal? As the financial system heals, banks will reduce their holdings of excess reserves and increase lending. This will result in an increase in the money multiplier and thus an increase in the money supply (even if the Fed takes no action). In late 2010, both measures of the money multiplier (M1 and M2) rose by about 10% from their lows, which contributed to a larger increase in the money supply. However, both measures of the money multiplier have since bounced along the bottom. Also, as the economy recuperates, the velocity of money will increase, meaning the same amount of money will have a larger impact on inflation and economic growth. (during 2010, the velocity of money increased by about 3% but since has set new lows). What are the implications for monetary policy? As the economy heals, the Fed's balance sheet will have a more significant impact on inflation and economic growth. Unless the Fed contracts the monetary base, inflation is likely to become a serious problem. The Fed knows this and will seek to implement a policy to keep this from happening. However, due to the complexity of the economy and financial system, the Fed will face difficulties in designing and implementing its exit strategy.
This leads to one of the more serious critiques of the second round of quantitative easing. Though most macroeconomists and monetary policy experts give the Fed very high grades for its response to the crisis in late 2008 (QE1), there is much more skepticism of QE2 and any future efforts at QE3. Basically, according to the critics, the benefits of QE2 are thought to be small (at best) while it adds to the complexity of the exit strategy.