By Mark Dow

There is zero correlation between the Fed printing and the money supply. If you don’t believe this, you owe it to yourself to study up on monetary policy until you do.

This is an issue that brings them out of the bunker like no other in economics. But if you are an investor, trader or economist, understanding—and I mean really understanding, not just recycling things you overheard on a trading desk or recall from Econ 101—the mechanics of monetary policy should be at the top of your checklist. With the US, Japan, the UK and maybe soon Europe all with their pedals to the monetary metal, more hinges on understanding this now than ever before.

And, as we saw recently, even many of the Titans of finance and economics have it wrong.

“Wrong? You’re saying they’re wrong? They have tons of money. They have long track records. I mean, they’ve seen it all. How can you say that? That’s just arrogant. Besides, did I mention they have tons of money?”

Here’s why the Titans are wrong

Brad DeLong had an entertaining piece on whales, super whales and men who hate the Fed, but the answer is much simpler than the one he offers. In fact, if you’ve ever been in the belly of a hedge fund, you know the answer to most everything is much simpler than it appears to the mere mortals on the outside.

The bottom line is the Titans are working from the wrong playbook. We’re all, to varying degrees, slaves to our experiences. Their formative experiences, almost to a man, were in the early 80s. This is when they built their knowledge and assembled their financial playbooks. They learned words like Milton Freidman, money multiplier, Paul Volcker, Ronald Reagan, and the superneutrality of money. Above all, they internalized one dictum: real men have hard money.

This understanding implies that an increase in bank reserves deposited at the Fed (i.e. “printing”) eventually feeds credit growth and thereby inflationary pressures; in other words, no base money increase, no credit growth. Only one problem: reality disagrees.

Here are the facts

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.

How is that possible? I thought in a fractional reserve system base money had to grow for credit to expand?

The answer is structural. The financial deregulation that began in the early 80s (significantly, the abolition of regulation Q) and the consequent development of repo markets fundamentally changed the transmission mechanism of monetary policy. Collateral lending is now king. Today, length of collateral chains and haircut rates—neither of which are determined by the Fed—define the upper bounds of the money supply, not base money and reserve requirements.

What about the relationship to inflation? Isn’t base money correlated to that? Here’s a graph, from this piece by central banking expert Peter Stella.

The X axis shows 5-year growth rate of base money (loosely defined) and the Y axis shows annual yoy inflation. That’s right. Nobody home here, either.

Don’t confuse liquidity with credit

The Federal Reserve only provides liquidity. The amount of liquidity it puts in the reserve system has no direct impact on the issuance of credit by banks or shadow banks. Only banks and shadow banks can create credit. And they lend either out of cash on hand or by repo-ing treasuries, mortgages, or deposits, if cash on hand is insufficient. And collateral that is pledged once can be pledged over and over and over (collateral chain). So, even though credit increases, the total amount of banking reserves on deposit at the Fed remains unchanged (though composition across banks may change).

So if the banks and shadow banks can just as easily repo their Treasury and mortgage holdings to finance lending, and there is no link between base money and credit creation, why is the Fed doing QE in the first place?

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