By Mark Dow
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.
“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-year 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 on 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 getting our money back out of the mattress and putting it back to work.
Risk taking always starts in financial markets, but eventually bleeds its 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.
Mark Dow is an economist, trader and the author of the Behavioral Macro blog.