Introduction

Last week, I published an article that hinted at the possibility that drawing conclusions from too little data can be misleading. I offered as an example a graph of the money supply (M2) with no comparison data. Some might conclude from that one graph that The Fed has been steadily expanding the money supply since 1985. But that conclusion may have flaws because of the limited data.

In a second graph, I presented data depicting activities at The Fed. Based on that data, some might conclude that the money supply should have jumped during 2008 – 2009. After all, does The Fed not control the money supply?

The proximity of the two graphs in my article might call either one or both of those conclusions into question.

In this article, I will take another look at the same data.

Combination

First, I combined the two graphs. Now, an observer can view two data series on a single graph. (I eliminated the required reserves because that added nothing to the analysis.)

In combining these two, I had to make one significant change. Since the number of “money dollars” (M2) amount to between 7 and 13 times the number of “reserve dollars,” I had to use two different scales: 1) Number of “money dollars” (M2) on the left in $billions and 2) Number of “reserve dollars” on the right in $millions.

These two changes help align the time frame for changes in these aggregates, but they lack one thing: rates of change. How rapidly has the quantity of money grown? How rapidly have the quantities of reserve balances grown? If, for example, total reserves rise by 20%, does the quantity of money increase by a comparable amount?

Rates of Change

To get some clue about the connections between the rate of changes in reserve balances and the rate of changes in the quantity of money, I have converted the scales on both the right and left axes to logarithmic scales.

Since many people seem not to fully grasp the concept of a logarithmic scale, I will give a brief layman’s description. (If I cannot make a logarithmic scale understandable, please consult with Doctor Google.)

On a logarithmic scale, for a value to double, the gap between the values remains the same; e.g., on a logarithmic scale, the distance between 4,000 and 8,000 equals the same distance as between 2,000 and 4,000. Thus, if an amount increases by 25% per year, on a logarithmic scale, that would result in a straight line, as opposed to the upward-sloping line that would result on a linear scale.

On this chart, I have converted the X-axes to a logarithmic scales to depict percentage increases better.

Increase in Excess Reserves

The logarithmic scales show that excess reserves (and, by deduction, total reserves) increased by a much larger percentage during the “quantitative easing (QE1)” than during QE2, activated in response to COVID.

According to popular theory, when excess reserves increased so dramatically in response to QE1, the quantity of money (M2) should have increased at a comparable rate.

In 2021, the increase in excess reserves (QE2) should have caused a much smaller percentage increase in the money supply (M2) than in 2008, but the money supply (M2) increased much more rapidly. Do the rates of increase in the quantity of money confirm this “theory”? The graphs expose contradictory results.

The Quantity of Money

Using logarithmic scales, we can now see that the supply of money has grown at about the same percentage rate for nearly the entire period covered by these charts.

Contrary to the popular theory that ties monetary growth to reserve expansion, the quantity of money did not increase as expected with the implementation of QE1. During QE2, however, the growth in money did increase as the theory would predict.

The different results between “QE1” and “QE2” provides us with a disconfirmation of the theory that The Fed creates “money.”

Conclusion

I have written this article to accomplish two purposes. First, to show that a person should seldom use only one data set to draw any conclusions, particularly with living systems like markets. Second, to challenge some of the popularly accepted assumptions made by people commenting about markets.

I have combined the data sets on the money supply and excess bank reserves to determine the correlation.

Because I consider rates of change important for these comparisons, I have converted the values on the X axes to logorythmic scales.

Having made these adjustments to these charts, I can make some more definitive statements about the relationships between the actions of The Fed and the money supply (M2).

First, the actions The Fed during QE1 had little or no effect on the quantity of money (M2) in the system. During QE2 The Fed may have facilitated, but did not represent the primary cause, of the increase in the quantity of money (M2).

Second, the lack of correlation between the level of excess reserves and the growth in the money supply (M2) confirms (does not prove) the importance of other influences outside The Fed on the growth in the money supply (M2).

I want to make the important point that you should never take affirmative statements about economic data without question. Many popular comments about market behavior contain false or misleading statements.

Be careful what you believe.