Thoughts on the expansion of the US monetary base

In the cover article of the latest edition of Monetary Trends, economist Yi Wen of the St. Louis Fed is cautioning US policymakers on the risks associated with having a large monetary base (i.e. bank reserves plus currency). In the article, Wen argues that the increase in the monetary base resulting from the Fed’s liquidity facilities (e.g. quantitative easing) since 2008 has the potential to lead to a rise in inflation and, in the longer term, an increase in unemployment.

To support his argument, Wen provides a summary of recent economic research concluding that increases in the rate of growth in base money generally have an opposite effect on the economy’s rate of growth. Also, he points to research suggesting that increases in the rate of growth in the monetary base have a negative impact on both inflation and unemployment.

While there is nothing out of the ordinary in Wen’s argument (it's essentially textbook monetarism...typical for the St. Louis Fed), it is surprising that the article does not mention the fact that the Fed now has the ability, as a result of recent changes in the Fed’s basic operational framework, to both maintain a large monetary base and defend the economy against inflation.

Recall that in October 2008 the Fed started paying interest on bank reserves at a prescribed remuneration rate. In several respects, this new mechanism represented a fundamental shift in the way monetary policy is implemented in the US because it enables the Fed to control both short-term interest rates and the size of the monetary base. The decision was at the time considered as so significant that economists of the NY Fed felt compelled to explain the implications of the new approach toward implementing monetary policy in a staff report in July 2009:

Paying interest on reserves breaks the link between the quantity of reserves and banks’ willingness to lend. By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves. In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves. (p. 9) (my emphasis)

In contrast, under the Fed's previous operational framework, it was generally understood that the central bank influenced interest rates and the level of economic activity by making changes to the quantity of reserves. This meant that to control inflation the central bank would have to raise rates by reducing the amount of excess reserves and the size of the monetary base as a whole. Under the Fed’s traditional framework, large quantities of excess reserves were usually regarded as an indication of future inflation.

Getting back to Wen’s article, it is clear that the author is still thinking of monetary policy in terms of the operational realities of the Fed’s previous framework. By solely focusing on the size of the monetary base and its potential negative impact on future inflation and by citing economic research relying on data that predates the Fed’s decision to pay interest on bank reserves, Wen appears to be suggesting that the potential risks to the economy should simply be mitigated by resorting to a reduction in the amount of base money. In my view, this would explain why the article avoids the more useful (and interesting) discussion about how best to use the Fed’s new operational framework to stabilize future inflation (via its influence over market interest rates) while also maintaining a large monetary base (via its authority to set the remuneration rate on reserves) in the event that it becomes necessary for the Fed to support its liquidity facilities for a period longer than anticipated.

To conclude, if the purpose of the article was truly to assist policymakers, as the final paragraph seems to suggest, the author should not have simply cited research on the possible impact of permanent increases in base money and concluded that "caution must be exercised such that long-term inflation does not increase". Rather, it would have been more helpful for the author to mention the ways in which the negative effects of a large monetary base can now be more effectively addressed than in the past as a result of the improved operational framework in place at the Fed since October 2008.

For more on the payment of interest on bank reserves, I recommend the following articles. If you're interested in reading about the implications of the new policy from a post-Keynesian perspective, see the excellent articles by Scott Fullwiler and Marc Lavoie:

Borio, C and P. Disyatat (2009): “Unconventional monetary policies: an appraisal” Bank for International Settlements Working Papers, No. 292.

Fullwiler, S. 2005. “Paying interest on reserve balances: It’s more significant than you think.” Journal of Economic Issues 39(2): 543–550.

Keister, T and J. McAndrews (2009): “Why are banks holding so many excess reserves?” Federal Reserve Bank of New York Staff Reports, No. 380.

Lavoie, M (2010) "Changes in Central Bank Procedures during the subprime Crisis and theit Repercussions on Monetary Theory", Levy Institute Working Paper, No. 606.