Thursday, September 21, 2017

The Future Path of the Monetary Base and Why It Matters

Now that the shrinking of the Fed's balance sheet has been announced, I thought it worth nothing what it means for the future path of the monetary base. Drawing upon the Fed's median forecast of its assets through 2025 that comes from the 2016 SOMA Annual Report, I was able to create the figures below. 

The figures show the trend growth path of currency and a series I call the 'permanent monetary base' extrapolated to 2025. The latter series is the monetary base minus excess reserves. This measure has been used by Tatom (2014) and Belongia and Ireland (2017) as a more reliable indicator of the monetary base that actually matters for monetary conditions. These two measures, which reflect the liability side of the Fed's balance sheet, are plotted along side the projected path of the asset side of the Fed's balance sheet. The first figure below shows this exercise in terms of dollars and the latter one is in log-levels.

What is interesting is that the Fed's median forecast of its assets eventually converges with the trend growth of currency which historically has made up most of the monetary base. Unsurprisingly, the permanent measure of the monetary base also tracks currency's trend path. Jim Hamilton does something similar here.  

So what are the takeaways? First, the Fed is expecting to confirm the temporary nature of the monetary expansion  under the QE programs. That is, the only major growth in the monetary base the Fed expects to persist is that coming from the normal currency demand growth that follows the growth of the economy. This endogenous money growth would have happened in the absence of QE. 

Second, the temporary nature of the QE programs, implied by these figures, is a key reason why these programs did not spur a robust recovery. For reasons laid out in this blog post and in this forthcoming article, there needed to be some exogenous permanent increase in the monetary base to spur robust aggregate demand growth. It never happened and neither did the much-needed recovery.  Instead we got the monetary regime change we never asked for.

Update I: See George Selgin's take on why QE was not very effective.

Update II: Brian Bonis, Jane Ihrig, and Min Wei from the Board of Governors just posted a note with the latest forecast of the Fed's balance sheet. It is updated to include the latest information from the recent FOMC meetings. My figures come from an earlier forecast and are a bit dated relative to these numbers. Their forecasted end value for the SOMA holdings ranges from $2.6 to $3.2 trillion. The median forecast I used above ends up at $3.2 trillion. So my trends would fit their high end estimates. 

However, their note is more nuanced than my graphs above. While they recognize that currency demand growth will be a big determinant of the future size of the Fed's balance sheet, they also recognize that depending on what the Fed does and what happens to banking regulation there could be an additional buffer in the Fed's balance sheet from excess reserves. Here is an extract:
Normalization of the size of the balance sheet occurs when the securities portfolio reverts to the level consistent with its longer-run trend. This trend is determined largely by the level of currency in circulation and a projected longer-run level of reserve balances. There is a great deal of uncertainty about the longer-run level of reserves, which could be affected by factors such as structural changes in the banking system, the effects of regulation on banks' demand for reserves, and the Committee's ultimate choice of a long-run operating framework. We show two scenarios. We assume that the longer-run level of reserve balances is either $100 billion (as in our April 2017 projection) or $613 billion (the median response from the Federal Reserve Bank of New York's June 2017 Survey of Primary Dealers and Survey of Market Participants)
Here are the relevant charts from their note:


  1. Another great post David. Thanks,

    I agree with the irrelevance theory. On a more technical matter: How does the Treasuries' demand for deposits at Fed which is up to USD500bn since 2015 and likely higher in the future fit into the equation?

    1. First off, the Treasury General Account isn't quite $500 billion. It has averaged about $240 billion since the May 2015 Treasury change to its cash balance policy. But to your point, during non debt-ceiling episodes, it has gone over $400 billion, and could potentially rise in the future. Since the Treasury General Account is a liability on the Fed's balance sheet, it must be matched by an asset. The implication in the charts above is that normalization will occur with SOMA at a higher level, and hence, the date of normalization of the size of the Fed's balance sheet will be earlier than if there were a low Treasury General Account balance. And it goes without saying, the Treasury could change its cash balance policy again at any time.

  2. I think helicopter drops are the answer, or as Bernanke called them. "money-financed fiscal programs. Then, the monetary expansion is permanent, and the results immediate.

    I still think QE roughly worked, but if QE is inert, it raises another question; Why shrink the balance sheet, or indeed, why not increase the balance sheet? What is wrong with giving taxpayers a tax break through QE?

    Also, I would like to see a discussion of Japan. As you know, the BoJ is proceeding with QE, and buys 10-year JGBs if ever the yield goes above zero. Soon the BoJ will own the majority of government debt. The government of Japan (and hence the populace and taxpayers) will owe the money to itself.

    What does this mean?

  3. And Beckworth contradicts himself:

    David Beckworth posted on “Macro and Other Market Musings”:

    “What makes this really interesting is that these wide swings in economic activity are not matched by similarly-sized swings in the price level. Most of the seasonal boom is in real activity. Put differently, there is an exogenous demand shock every fourth quarter where prices remain relatively sticky so real activity surges. This is a microcosm of demand-side theories of the business cycle”

  4. Beckworth: "This measure has been a MORE RELIABLE INDICATOR of the monetary base that actually matters”

    Milton Friedman: "The only relevant test of the validity of a hypothesis is comparison of prediction with experience."

    There is no expansion coefficient for currency. An increase in the currency component is contractionary, unless as practiced by the FRB-NY’s trading desk, increases in currency (since the trend of the non-bank public’s holdings of currency is up, ever since 1930, return flows are purely seasonal & cannot therefore provide a permanent basis for bank credit and money expansion) are offset / accompanied by concurrent expansions of Reserve Bank Credit.

    In our Federal Reserve System, 92 percent of “MO” (domestic adjusted monetary base) was represented by the currency component prior to Oct. 6, 2008. And the currency component of MO is so prominent, and the proportion of legal reserves so negligible (and declining); that to measure the rate-of-change in currency held by the non-bank public, to the rate-of-change in M1 is, yes, to measure currency vs. currency (cum hoc ergo propter hoc); in probability theory and statistics, not a cause and effect relationship.

    Complicating the measurement of the monetary base is the fluctuation in the percentage of foreign currency circulation, to domestic currency circulation. The FED’s research staff estimates that foreigners hold one half to two thirds of all U.S. currency (this spread can result in a wide margin of error). Inflows and outflows of foreign-held U.S. currency (seldom repatriated) are attributed to political, and price, instability (as well as to seasonal flows), and all are immeasurable in the short run. I.e., the domestic monetary source base equals the monetary source base minus the estimated amount of foreign-held U.S. currency.

    The “shipments proxy” estimate of foreign-held U.S. currency uses data on the receipts and shipments of currency, by denomination, at the Federal Reserve’s 37 cash offices nationwide (note: > 80 percent of foreign-held U.S. currency are $100.00 bills). Because of its influence on the DAMB, quarterly estimates of foreign-held U.S. currency are reported in the Feds “Flow of Funds Accounts of the United States” & in the BEAs estimates of the net international investment position of the United States.

    The volatility of the (1) K-ratio, the public’s desired ratio of currency to transactions deposits (or currency-deposit-ratio), and the volatility in (2) the ratio of foreign-held, to domestic U.S. currency, both influence the trend rate for the cash drain factor (the movement of the domestic currency component of the DAMB). And the evidence points to sizable (& unpredictable), shifts in the money multiplier (MULT – St. Louis), for the constantly changing shifts in the composition of the “M’s”.

    Beckworth: “such increases in the nominal stock of money will have NO LASTING EFFECT ON REAL VARIABLES, though they may in the short-run. Third, given the above claims, real money demand must be relatively stable.”

    Beckworth: “The key argument of this paper is that the Fed failed to generate a robust recovery because it could not credibly commit to a permanent expansion of the monetary base”…”Its relevance includes implications for the distinction between permanent and temporary monetary base injections.”

    Beckworth and Scott Sumner: “if the monetary base is increased in the current period but is expected to be fully offset in some future period there will be zero change in the price level. This will happen via a decline in velocity.”


    Quantitative Easing and Money Growth:
    Potential for Higher Inflation?
    Daniel L. Thornton Economics LLC

    See: “Bank Reserves and Loans: The Fed Is Pushing On A String - Charles Hugh Smith”

  5. Because money is not neutral, but robust, you can't run a regression test against the historical time series. I cracked the code 38 years ago.

  6. What it means is that Bankrupt u Bernanke caused the GFC all by himself. BuB drained money flows (proxy for inflation for the last 100 + years), for 29 contiguous months, turning otherwise safe assets into impaired assets (upside down / under water).

  7. Then BuB permitted short-term robust money flows (proxy for real-output for the last 100 + years), to collapse in the 4th qtr. of 2008:

    POSTED: Dec 13 2007 06:55 PM |
    The Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006.
    10/1/2007,,,,,,,-0.47,... -0.22 * temporary bottom
    11/1/2007,,,,,,, 0.14,,,,,,, -0.18
    12/1/2007,,,,,,, 0.44,,,,,,,-0.23
    1/1/2008,,,,,,, 0.59,,,,,,, 0.06
    2/1/2008,,,,,,, 0.45,,,,,,, 0.10
    3/1/2008,,,,,,, 0.06,,,,,,, 0.04
    4/1/2008,,,,,,, 0.04,,,,,,, 0.02
    5/1/2008,,,,,,, 0.09,,,,,,, 0.04
    6/1/2008,,,,,,, 0.20,,,,,,, 0.05
    7/1/2008,,,,,,, 0.32,,,,,,, 0.10
    8/1/2008,,,,,,, 0.15,,,,,,, 0.05
    9/1/2008,,,,,,, 0.00,,,,,,, 0.13
    10/1/2008,,,,,,, -0.20,,,,,,, 0.10 * possible recession
    11/1/2008,,,,,,, -0.10,,,,,,, 0.00 * possible recession
    12/1/2008,,,,,,, 0.10,,,,,,, -0.06 * possible recession
    Trajectory as predicted:

  8. The notion that something that took nine years to bring about and stabilize and then will take another 4-5 years (closer to 5 years in this note) to eliminate was "temporary," suggests that the term is meaningless. Worse: "First, the Fed is expecting to confirm the temporary nature of the monetary expansion under the QE programs." There was little or no "monetary expansion" under QE. The balance sheet expansion was largely sterilized by the rise in excess reserves. Limited monetary expansion explains why GDP was so weak and inflation declined, as well as why the recovery and expansion were so weak, not that it was "temporary" or that the balance sheet expansion was monetary or stimulative. Similarly the contraction in the balance sheet itself will have no direct effects on inflation or GDP, if it is done correctly, i.e a quick reduction in MBS and other assets matched by equal reductions in excess reserves. The country will recoup some of its efficiency, resource and productivity losses, however. If the Fed is as confused over the next five years as it has been for the past 9 years, this rosy outcome will be unlikely.

    I think this discussion misses the point that the excess assets on the Fed's balance sheet that will be eliminated over the next 4-5 years will have to be matched by a like amount of excess reserves. An elimination of about $2.2 trillion over this period matched by a reduction in MBS and Treasury securities will leave the Fed in the right spot without disrupting monetary aggregates or total money credit. The sooner the better, but the current plan takes too long. And the FOMC does not seem to understand that this is going to require the virtual elimination of the IOER, a desirable result on efficiency, public finance and equity grounds. Barring this, reductions in the asset side of the balance sheet will come out of currency and required reserves, creating adverse shocks to monetary aggregates, spending and real GDP.

  9. I think it's important to not word it: QE was not effective
    but to say: QE was rendered much less effective by IOR.

    The next time we have a crisis, some people will be against QE when QE in combination with an aggressively negative rate of IOR and an announcement of NGDPLT should get us back on track really quickly.

  10. Money is robust, otherwise, there would be no distributed lag effect for money flows, let alone lags that have been mathematical constants for over 100 years.

  11. And the transactions velocity of money has varied 3 times that of the money stock (1959-1996), for the published period. How can money be neutral when its rate of utilization varies?