February 16, 2015

One of the most persistent beliefs in the world of economics today is that the Fed’s QE (Quantitative Easing) adds to bank reserves but does not directly boost the US money supply. The popularity of this belief is remarkable considering that anyone who bothers to do a few simple monetary calculations will quickly see that it is completely wrong. The fact of the matter is that every dollar of QE adds one dollar to bank reserves AND one dollar to the economy-wide money supply.

Before I briefly explain the process by which the Fed’s QE injects money directly into the economy, I’ll show the simple calculations that anyone commenting on monetary matters should do. The calculations are based on the fact that new US dollars can only be legally created by the commercial banking system and the Fed.

The commercial banks create money when they make loans or monetise assets. More generally, commercial banks create money via an increase in credit. The increase in total Bank Credit over a period is therefore a rough, but reasonable, estimate of the MAXIMUM amount of new money that could have been created by the commercial banking system over the period. Note that changes in Bank Credit are recorded in the Fed’s H.8 Release.

At the end of August-2008, which was just prior to the start of the Fed’s first QE program, total Bank Credit was around $9T (9 trillion dollars). At the end of January this year it was around $11T. This means that the commercial banks have collectively created a maximum of 2 trillion new dollars since August-2008. They might have created significantly less than 2 trillion new dollars, but they have not created significantly more than that.

Let’s now consider what happened to US True Money Supply (TMS) over the same period, noting first that TMS is the sum of physical currency in circulation, demand deposits at private depository institutions and savings deposits at private depository institutions. TMS only counts money within the economy. It does not count bank reserves.

From the end of August-2008 through to the end of January-2015, TMS increased by $5.1T. Since we know that commercial banks created a maximum of $2T over this period, we know that at least $3.1T came from somewhere other than the commercial banking system. And since we also know that new US dollars can only be created by the commercial banks and the Fed, we therefore know that the Fed’s QE must have directly created a minimum of 3.1 trillion new dollars.

I’ll now move along to the process by which the Fed’s QE boosts the money supply.

The first point that must be understood is that the Fed conducts its asset purchases and sales via Primary Dealers (PDs). In many cases the PDs are banks, but in such cases the PD part of the business is separate. Of particular relevance, the PD part of one bank will maintain demand deposit accounts at other banks and these demand accounts receive the payments when the Fed buys assets from the PD.

Next, for the sake of explanation let’s assume that PDA (Primary Dealer A) is a subsidiary of Bank A and maintains a demand deposit at Bank B. When PDA sells assets to the Fed, the Fed deposits payment in the form of newly-created dollars into PDA’s demand account at Bank B. Since customer deposits are liabilities of banks, if the process ended with the Fed depositing new dollars in PDA’s account at Bank B it would increase Bank B’s liabilities by the amount of the deposit. To make the process balance-sheet-neutral for Bank B and the banking system as a whole, the same amount that was deposited in PDA’s demand account at Bank B is added to Bank B’s reserves at the Fed. In effect, the Fed adds dollars to demand accounts within the economy that are covered by reserves at the Fed.

One dollar of QE therefore involves one dollar being added to a demand deposit within the economy (part of the money supply) and one dollar being added to a reserve account at the Fed.

Let’s now take a look at how the mechanics of the QE process as outlined above explain the change in the money supply since the beginning of the Fed’s QE back in 2008.

I mentioned above that if we only consider the amount of money created by the commercial banks then we find that at least $3.1T is unaccounted for. If my analysis is correct then the Fed’s QE must have directly added a minimum of $3.1T to the money supply.

A very rough approximation of the amount of new money added by the Fed over a period is the change in Reserve Bank Credit, which can be determined by referring to the Fed’s H.4.1 Release. The increase in Reserve Bank Credit from August-2008 until January-2015 was $3.6T, which is in the right ballpark. However, a more accurate calculation of the amount of new money created by the Fed can be done using the knowledge that a) each new dollar added to the economy by the Fed will be associated with one dollar of additional reserves, and b) reserves at the Fed will remain at the Fed unless they are removed by the Fed or they are converted into physical notes/coins (in response to increased demand by the public for physical currency). The amount of money created by the Fed since August-2008 should therefore be equal to the net increase in Non-Borrowed Reserves at the Fed plus the increase in Physical Currency in Circulation over the same period.

The figure comes to $3.4T, which is roughly what it needs to be to explain the increase in True Money Supply.

A separate question is: Why hasn’t the large Fed-promoted increase in the US money supply led to a substantial increase in the ‘general price level’?

This is a question for another time as this post is already too long, but suffice to say right now that:

1) There has been a significant increase in the ‘general price level’ as a result of the monetary inflation, just not as significant as would normally be the case.

2) The general price level’s smaller-than-normal response to the money-supply increase of the past several years is probably related to the Fed’s abnormally-large role in the money-creation process. During more normal (pre-2008) times, almost all new money is created by the commercial banks. Consequently, the first receivers of the new money tend to be within the ‘general public’ (home buyers/sellers, private businesses, etc.). However, during the period since August-2008 about two-thirds of all new money has been directly created by the Fed. This means that the first receivers of most of the new money have been bond speculators, and that the second, third, fourth and fifth receivers of the new money have probably been bond speculators or stock speculators.

In conclusion, when I say that the Fed’s QE directly boosts the money supply I’m not stating an opinion or giving my interpretation of how the monetary system works. I’m stating a fact.

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