Money Supply and Bank Reserves

Introduction

The fact that we perpetuate false or inaccurate theories causes at least one problem for understanding money and its role.

For years economic classes have taught that the Federal Reserve controls the supply of money. When they buy government bonds from banks, they pump reserves into the banks’ reserve accounts, and that addition to reserves somehow causes an expansion in the supply of money.

We continue to talk in these terms even though (thanks to Ben Bernanke) we now have evidence that that might not be the case. And possibly never was the case.

Contradiction

This chart shows the money supply (the Blue Line — scale on the left) rising continually from April 2014 to April 2019.

During that same period, bank reserves (the reddish line — scale on the right) declines continuously. (The thin green line at the bottom shows required reserves during that same period.)[1]

Figure 1 -2014-04-01 to 2019-04-01[2]

According to popular theory, this behavior should not happen. When bank reserves decline, the money supply should also decline.

Real behavior, at least for this period, seems to contradict popular theory. The data and the theory both cannot be true. Either the data contains an error (or an unknown influence), or the theory contains an error.

An Apparent Connection

If we look at historical data from past periods, we can see how people made a connection between bank reserves and the money supply.

During the period from 1963 to 1973, both bank reserves and the money supply traced similar patterns. Only in the latter part of those ten years did the patterns diverge.

Figure 2 – 1963-01-01 to 1973-01-01

In the chart below, as bank reserves rose from 1985 to roughly 1989, the money supply followed a similar pattern. Only at the end of this period from 1989 into 1990 did the patterns of bank reserves and the money supply diverge.

Figure 3 – 1985-04-01 to 1990-04-01

The two periods represented by these two charts seem to indicate a reasonably close connection between the rise of bank reserves and the increase of the money supply. They seem to confirm the popular theory that the Federal Reserve drives the growth of the money supply.

Can we reconcile the apparent contradiction between this evidence and that shown in the first chart?

Sign of Broken Connection

When we look at a longer period — from 1985 to 2008, we have evidence that no connection exists between bank reserves and the quantity of money.

Figure 4 – 1985-04-01 to 2008-04-01

Could this chart, and the first chart, provide signs that a pre-existing connection between bank reserves and the money supply had broken?

If there was a connection that no longer exists, that calls the original theory (or the data) into question.

Let’s look at a longer period of time to see if it gives evidence as to which to question — the data or the theory.

A Break From the Theory

If we look at a chart for an extended period, from 1985 to 2019, we see that the data seems to have had a fairly long break from the theory.

Figure 5 – 1985-04-01 to 2019-04-01

During that period bank reserves rose at a relatively insignificant rate up until 2008. During that same period, the money supply grew at a much faster pace.

Then, in 2008 — in response to the financial crisis of that same year, bank reserves grew at a phenomenal rate until roughly 2015 at which time the quantity of bank reserves began to decline. During this entire period, from 1985 two 2019, the money supply grew at a fairly consistent rate, never in real correlation with the level of bank reserves.

Can we draw any firm conclusions from the evidence that I have given above?

Conclusion

We need to find some way to reconcile the apparent conflict between popular theory and the data that I have provided in the charts above.

If the theory contains no flaws, a very powerful influence must exist to cause the data to diverge so far from what the theory would dictate.

If, on the other hand, the data reflects reality, we must conduct a thorough examination of the popular theory.

In future posts, I will explain why the popular theory contains fatal flaws. A more accurate theory will explain and predict results consistent with the data given.


Footnotes:

  1. I divided the Reserve Balances Required, which were stated in millions of dollars, by 1000 to convert the quantities into billions of dollars, making the figures uniformly comparable between total reserves and required reserves.
  2. The Federal Reserve Economic Data (FRED) site at the St. Louis reserve bank generated all the charts used in this article.

 

Fed Funds Explained

The financial press makes a big deal about whether the Federal Reserve will either leave the fed funds rate where it is, raise it, or get really silly, and drive interest rates below zero. In making these comments, however, they seem to assume that everyone understands the fed funds market and how it operates.

Fed Funds Redux - 16
Fed Funds Market Dynamics

Can the Fed actually control interest rates? And, does the fed funds rate actually have a significant influence on broader market interest rates?

To answer these questions one must first understand what is the fed funds market and how does it operate. To help you gain this understanding I have put together a presentation entitled “Fed Funds Explained.” You can find that presentation at this link: Fed Funds Explained.

Fed Funds Rate; Who Cares?

People who care about financial markets have speculated about the effects of the Fed “raising” the fed funds rate. Would it cause the stock market to decline? Would the economy return to recession? Would mortgage rates start to rise and kill the housing recovery?

A person does not need a plethora of charts and graphs to gain a basic understanding of relationships between fed actions, fed funds rates, financial markets, and economic activity.

First, the Fed does not “set” interest rates in any market, including the fed funds market. Interest rates consist of the ratio of future money to current money. As a ratio— calculated from two independent variables — an interest rate is a dependent variable. It cannot be set or determined directly. One or more of the dependent variables must change in order for an interest rate to change.

Second, participation in the fed funds market is limited to financial institutions that have accounts with the Fed. As a closed market the total number of dollars borrowed equals the total number of dollars lent. Net lending in the fed funds market equals zero. Thus, the level of total excess reserves does not affect rates. It’s the interbank imbalances in reserve accounts that cause fed funds borrowing. So what determines interest rates?

Third, because of the closed nature of the fed funds market, the Fed funds rate is determined by the relative levels of excess reserves between banks in the system. To discover the determinants of fed funds rates, you need to examine the factors that affect those relative excess reserve balances. Those factors can include: Fed open market activities, which either increase or decrease excess reserves in individual banks; the demand for bank funds (i.e. deposit liabilities); or the willingness of banks to create more deposits for the purchase of notes.

Fourth, with a banking system awash in excess reserves, what would cause rates to change? How many securities would the Fed need to sell to have the slightest effect on the fed funds rate? A lot. Simply announcing a rate hike does not change that. The Fed funds rate is zero because banks don’t have a need for reserves. Fed action has not changed that.

I will address, in more detail, questions raised by my comments above in future posts.

Bye