The The “monetary base” is not a base for the expansion of new money & credit. Legal reserves are that base (even when considering reserves are no longer binding).

No money figure (M1,M2 et al.), standing alone is adequate as a “guide post” to monetary policy.

Also, there are several errors in the construction of the monetary aggregates:

(1) M1 increasingly overstates the quantity of the means-of-payment money. This upward bias is the consequence of classifying Savings and Loan and Credit Union Deposits as commercial banks (but not Mutual Savings Bank deposits) as demand deposits, rather than inter-bank demand deposits. M1 thus includes both the Negotiable Order of Withdrawal (NOW) account balances and the thrifts’ balances in the commercial banks – a double counting of our means-of-payment money.

(2) M2 erroneously includes MMFs in its definition (a sizable #). MMFs are the customer’s of the commercial banks. They are financial intermediaries/transmitters. Monetary savings are never transferred from the commercial banks to the intermediaries (non-banks); rather are monetary savings always transferred through the intermediaries. Whether the public saves or dis-saves, chooses to hold their savings in the commercial banks or to transfer them to intermediary institutions will not, per se, alter the total assets or liabilities of the commercial banks; nor alter the forms of these assets or liabilities.

(3) It is also inaccurate (for the cataloguer of economic statistics) to exclude the Treasury’s General Fund Account from the assets included in M1 (with the exception of WWII). No one has established any unique price effect of federal outlays, as compared to state and local government outlays, or expenditures by the private sector. Of course, the shifting of funds to and out of the Federal Reserve banks has a dollar for dollar effect on member bank reserves, but that is another problem that can be, and is dealt with through open market operations…the money supply is actually unknown & unknowable.

What’s transpired is that the “trading desk” has altered the rate-of-change in “member bank” legal reserves, in the last several weeks.

FOMC policy has gradually “tightened” relative to the normal seasonal flows. And perhaps the “transactions velocity” of money is gradually recovering as well.

I.e., the FOMC stopped “validating” the current or “asked” price levels, as demonstrated by the recent fall in long-term interest rates, as well as the weak oil & gasoline prices.

A much better explaination of what an exit strategy might look like comes from an interview Bill Dudley gave to the Economist magazine last month:

http://www.economist.com/businessfinance/displayStory.cfm?story_id=13768746

Given that the fed is doing what it was built to do (offer credit when private sector doesn’t want to), isn’t the most important question “how will the fed sell its assets when private credit creation picks up?”

Who will buy the assets? Does bernanke have to be a good trader to unload the assets in a timely manner so that we don’t go into a credit creation phase with a very large monetary base? What will losses on some of the crappier assets do to the equity of the fed? What historic events give one confidence that the Fed will decide and be able to shrink at the right time?

Thanks.

-Ty

Pero hay que tener cuidado con M2: no es amplio lo suficiente para recoger bien los efectos de los cuales indico aqui’. M2 recoge tambien el aumento de liquidez que demanda el sector privado para protegerse, en este caso en forma de depositos. M3 tambien refleja hasta cierto punto el mismo fenomeno, con los flujos que entran los money markets cuando salen de otros mercados.

Por lo tanto, una expansion de M2 no quiere decir necesariamente que haya vuelto la demanda para sacar credito.

Ojalá que tuviera mas tiempo para jugar con los datos!

Y gracias por el link: voy a echar un vistazo a tu blog. Seguro.

Saludos,
Mark

Thanks. When thinking about these issues it is fun to play around with FRED 2 (http://research.stlouisfed.org/fred2/).

I have posted a couple of interesting charts in my blog (http://randomspaniard.blogspot.com/) on M2 and US consumer credit. I wonder to what extent what seems like a recent (past four months) stalling in M2 is the result of the deleveraging of the consumer. I think this is related to your third point.

Why? Because M2 is not broad enough to capture the collapse in credit to (debt of) the private sector. I cited it because it was handy and illustrates the disconnect between the base money that many are focusing on and the broader monetary measures that correlate better to the things that matter.

To summarize, the points I have been trying to make in this regard are, I think, straightforward. And I am trying to make them because when one goes below the surface one sees that the facts tend to contradict received wisdom on the subject. The points are:

1) Despite daily assertions to the contrary, base money stopped expanding in December.

2) There only correlation between base money and the dollar since the crisis hit in September has been a negative one (the dollar has tended to get stronger as base money expanded, and tended to sell off once base money growth flattened out.

3) From an economic standpoint, what matters to inflation, activity, and, to some extent, the dollar is broader credit–much broader than base money or M2 can capture. When credit card holders default or have their lines cut, when Six Flags defaults, or when homeowners “modify” their mortgages, this contracts credit to the private sector. This is clearly shrinking (I have seen the estimates but can’t track them down at present). Anyway, this is the very definition of deleveraging.

4) People seem to be focusing on the money supply, rather than the factors underpinning changes in demand. Of course supply equals demand, by definition, but the point is that demand is the driver much more than supply.

The proper concept of the Fed balance sheet–and the one I refer to–comprises all of the Fed’s activities.