Does the Fed Control the Money Supply?

It depends how you define money.

The Federal Reserve controls the monetary base, and has vastly increased it as a result of quantitative easing:

But that’s not the same thing as the money supply. The money supply is controlled by fractional lending by the banking institutions. More “money” comes into existence as more credit is extended. Banks can lend and lend and lend the monetary base up to the reserve requirement (ten times the monetary base, at present). You’d think that profit-hungry banks would lend all the way up to the reserve requirement, but right now that isn’t the case — a huge amount of the monetary base is sitting unused as excess reserves:

This means that while the monetary base has tripled, the money supply (M1) has not surged nearly as much:

But there is a much bigger factor here; M1 only deals with the obvious side of money supply — lending by financial institutions to businesses and consumers. There exists another banking system between banks and hedge funds where credit expansion takes places much less directly and obviously, via securitisation and rehypothecation — for example collateralised-debt-obligations (CDO), mortgage-backed-securities (MBS), etc. Here’s a recent chart of credit creation via these pseudo-monies:

Simply, the Fed’s huge expansion of the monetary base has still failed to prevent the contraction of this strange and exotic part of the “money” supply stemming from the 2008 Lehman incident, and surely to be significantly worsened by the ongoing implosion in Europe. It has failed to prevent the sector from deflating and sucking down the wider economy.

In the years preceding 2008 the definition of “money” became extremely loose. When securities made up of sub-prime mortgages which are in arrears comes to pass for “money” — and came to stand on balance sheets as debt — it should have been painfully obvious that modern finance had mutated into an uncontrollable monster, and that no amount of quantitative easing could prevent prevent the inevitable credit contraction from blown-up asset prices tanking.

The shadow banking sector was never “too big to fail”; it was too monstrous to succeed.

14 thoughts on “Does the Fed Control the Money Supply?

  1. I don’t know if this is really complicated or I’m just more stupid than I thought, for I am never certain that I am viewing and understanding with a reasonable perspective or not. It seems that while the Fed is taking steps to increase the money supply (I assume one reason is to increase the supply of credit that ‘can be’ made available to borrowers) the Government is instituting more stringent regulatory requirements and penalties on commercial banks that cause them to reduce their commercial lending. So those banks keep these excess funds in low interest government securities at much lower interest rates than could be had from commercial borrowers (this is good for the government’s debt service but I cannot see that it helps the economy in other ways). So when earnings season arrives, the banks get dinged for disappointing earnings. Duh! I’m guessing that this is another big factor in the continuing unemployment caused by banks failing to lend to small businesses trying to start-up or expand. This is the type of risk that federally insured commercial banks are chartered to take, but we have all our policy-makers mesmerized by the insane risk that went on in the shadow banking system that led to the recent crash.

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