Who controls money supply if the fed does not?

Question

This whitepaper states (bold mine):

According to the consensus view, the two leading culprits of inflation risk today are the fiscal deficit and the money supply. To illustrate, take this CNBC headline, “The ballooning money supply may be the key to unlocking inflation in the US,” which precedes the quote that “the Fed may not be in control of Money Supply growth, which means they won’t have control of inflation either, if it gets going.” News flash: the Fed hasn’t controlled the money supply for years (ever since the Volcker experiment in the very early 1980s). The Fed sets the interest rate (the price of money), not the quantity of money.

I am trying to make sense of it, since my search results only point to the fed or more generally central banks controling the money supply. For example in this same stackexchange we have this question where the accepted answer explains how the "Federal reserve manages money supply in various different ways".

Could someone provide some clarity, and help me understand what the author means?

Answer 1

Central banks do control money supply you can read that in any macro textbook (Mankiw Macroeconomics, Blanchard et al Macroeconomics or Romer Advanced Macroeconomics) or you can have even look at highly cited papers such as McLeay et al "Money creation in the modern economy (paper with over 1k citations), where authors state:

The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates.

I think the white paper you cite confuses control with instruments they use. In fact I am sure of this because in the next sentence Montier & Pilkington state:

The Fed sets the interest rate (the price of money), not the quantity of money.

This was true most of the time for last half a century or so, but setting interest rate (price of money) does control the quantity of money (again see any macro textbook or the quote from the highly cited paper above). As McLeay et al clearly state:

The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates.

So already the statement about Fed not controlling money supply is simply false.

It is true that central banks typically use interest rates or bank regulation when they are conducting monetary policy, but interest rates determine what quantity of money in economy there is. Interest rates determine what the total amount of money in the economy will be created, even if central bank only creates some high powered money and then all other money is created by private banks.

This would be equivalent of saying in a situation where there is shortage of some good due to price celling policy which sets maximum price below equilibrium market price, that the shortage is not consequence of price celling policy, because regulators do not control directly quantity produced but just price and quantity produced is controlled by private firms. This completely ignores that quantity produced is a function of price. This would be equally absurd as saying that you are not in control and responsible for death of a person you pushed in front of a train because you only controlled your push not the train.

However, lets cut the authors some slack since they are investors not professional economists, so lets just assume they meant to say that Fed since Vockler never controlled money supply via direct changes to money supply, and they controlled it only via interest rate instrument.

This would still be incorrect. Fed still even post Volcker directly increase or decrease money supply via open market operations (OMO), that is purchase of assets and securities on open market in exchange for newly created money (see Mankiw Macroeconomics pp 337). Monetary policy using OMOs is more rare (in some countries like US), than monetary policy using interest rate instrument, but we just had several rounds of QE and QE is just OMO on large scale (see Fed QE explainer here).

Consequently, saying that Fed does not control money supply is false prima facie.

1. Controlling interest rates is precisely how central banks typically control money supply most of the time.
2. Even if we will give the authors a benefit of the doubt and assume that the authors just don't know what control of money supply means so they just meant to say that Fed does not directly change money supply anymore, the statement would still be false. Fed recently did several rounds of QE and also bought millions worth of US bonds which directly increases quantity of money in the economy (as opposed to interest rate which determine the quantity of money indirectly).

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PS: professional investors most of the time are not really reliable sources when it comes to economics. The paper you cite makes several other claims that would not stand academic scrutiny. Many professional investors are often making claims that contradict even 101 economics, like for example Peter Schiff’s writings on gold standard which are just plain nonsense as well.

Answer 2

We need to define, first, what money supply is. Central banks use the monetary aggregate M0 in order to influence what is called "money multiplier" that is the ratio between the monetary base (cash plus banks' reserves) and the broader aggregate (that is M2/M3, depending if we are speaking about the US or other countries); or (and that's the same) the reciprocal value of the required reserve ratio (set by the monetary authority). So yes, by controlling the monetary base the FED (and the other central banks) can control the money supply.

Now, this is true under the assumption that money is completely exogenous, i.e.: the money supply is determined only by the decisions of the monetary authority. But since Wicksell, we know that at least partially the money supply can be determined by the decision of the public and that's why the FED uses the interest rates to control the money supply. But, again, by setting interest rates the FED controls how much money there is in the economy (via the credit system for example). So, in the end, yes: the FED is in control of the money supply either directly (by using the monetary aggregates control) or indirectly (by setting interest rates).

Answer 3

I disagree with the given answer. Setting interest rates is not identical to controlling money supply.

The Fed is not trying to control money supply (M1, M2,...), it mainly tries to control interest rates and largely disregards money supply in policy decisions. QE helps reduce rates on a broader scale, with the (potential) side effect of increasing money supply. However, it may not (immediately) increase money supply, if held as excess reserves (the FED is buying financial assets from commercial banks and other financial institutions).

Interest rates and money supply are historically taught via the money multiplier. However, speaking of money multipliers in the US is outdated. The reserve requirements are zero and the FED uses a so called ample-reserve regime. St.Louis Fed research claims it's best to forget what we learnt about money aggregates in undergrad Econ.

Other links of interest are New York FED -Money Supply which states that "In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money supply growth expired, the Fed announced that it was no longer setting such targets, because money supply growth does not provide a useful benchmark for the conduct of monetary policy."

As well as FED - what is money supply which states "Over recent decades, however, the relationships between various measures of the money supply and variables such as GDP growth and inflation in the United States have been quite unstable. As a result, the importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time".

P.S. The Fed QE explainer linked in the other answer also states that "Critics of QE warn that because QE increases the monetary base (which is essentially money supply) significantly, dramatic inflation could result ..... If the money supply were to grow at a rapid rate, the resulting increase in economic activity could cause inflation to accelerate and expectations of future inflation to increase. The Fed, however, remains confident that its programs, including incentives for banks to retain their reserves, will prevent such an outcome."

Edit

Supposedly no source I cited states that the FED does not control money supply. Well, stating "money supply (growth) does not provide a useful benchmark for the conduct of monetary policy" is a fairly decisive assertion that (broad) money supply is probably not tightly controlled by monetary policy (as opposed to - at least some - interest rates).

Generally, the FED only controls the monetary base and the FED "injecting" money need not translate into changes in broader aggregates. The money supply, under any definition other than the base, is no more an instrument of the monetary authority than that of public and private entities because most of the money instruments included in any of the various definitions of money are privately issued.

Ultimately, it matters what happens in the data. So let's look at official money supply aggregates. I am using the FredData.jl API that is also used by the NY Fed's DSGE model. The code is fully reproduceable, provided you have a FRED Developer API key and Julia installed on your machine.

First, load the required modules:

using Plots
using PlotThemes
using Dates
using FredData
f = Fred()

Fetch the data using standard FRED IDs

mb = get_data(f, "BOGMBASE")
m1 = get_data(f, "M1SL")
m2 = get_data(f, "M2SL");

Plot the data (normalized to Dec 2005 = 100 for each series), and add shaded regions for the timing of the 3 phases of QE.

start = 564
ends = 730
theme(:juno)

plot(mb.data.date[start:ends,:],[mb.data.value[start:ends,:]./mb.data.value[start]*100, 
                                m1.data.value[start:ends,:]./m1.data.value[start]*100, 
                                m2.data.value[start:ends,:]./m2.data.value[start]*100] ,
                                label =["MB, $(mb.data[start,:].date) = 100" "M1, $(mb.data[start,:].date) = 100" "M2, $(mb.data[start,:].date) = 100"], 
                                size = (800,500),
                                legend = :topleft,
                                title = "Does the Fed really control the money supply?")

vspan!([Date(2008,10,01), Date(2009,03,01)], linecolor = :grey, fillcolor = :grey, opacity = 0.3, label ="QE1")
vspan!([Date(2010,11,01), Date(2011,06,01)], linecolor = :grey, fillcolor = :grey, opacity = 0.3, label ="QE2")
vspan!([Date(2012,09,01), Date(2014,10,01)], linecolor = :grey, fillcolor = :grey, opacity = 0.3, label ="QE3")

Neither M1 nor M2 seem to be affected much, if at all, by the sizeable increase in the monetary base. As a sanity check, one can display monetary aggregates in relation to the base.

plot(mb.data.date[start:ends,:],m2.data.value[start:ends,:]./mb.data.value[start:ends,:]*1000, 
                                label ="M2/MB", 
                                size = (800,500),
                                legend = :topright,
                                title = "Does the Fed really control the money supply? \n M2 Money Stock / Monetary Base", 
                                titlefontsize=10)

You can see a massive decline in broad money supply relative to the increase in base. The RichmondFed writes that "in the post-2008 world, the Fed controls inflation by controlling the interest rate on excess reserves. Thus, an increase in the monetary base no longer necessarily leads to an increase in the money supply or, therefore, to an increase in the price level."

However, even looking at a longer time span indicates that total money supply is all but directly impacted by monetary policy.

If that does not convince, I am citing a few sections of Romer's Advanced Macroeconomics 5th ed because it is one of the text books mentioned by someone else.

• P. 221

Aggregate measures of the money stock, such as M2, are not set directly by the Federal Reserve but are determined by the interaction of the supply of high-powered money with the behavior of the banking system and the public. Thus shifts in money demand stemming from changes in firms’ and households’ production plans can lead to changes in the money stock.

• P. 608.

But despite many economists’ impassioned advocacy of moneystock rules, central banks have only rarely given the behavior of the money stock more than a minor role in policy. The measures of the money stock that the central bank can control tightly, such as high-powered money, are not closely linked to aggregate demand. And the measures of the money stock that are sometimes closely linked with aggregate demand, such as M2, are difficult for the central bank to control. Further, in many countries the relationship between all measures of the money stock and aggregate demand has broken down in recent decades, weakening the case for money-stock rules even more. Because of these difficulties, modern central banks almost never conduct policy by trying to achieve some target growth rate for the money stock.

Bottom line is that frequently people write “money supply” as shorthand for “monetary base”. Similar to log or ln being used for the natural logarithm because many practitioners implicitly assume log is of base e (in their research). However, this unfortunately can cause a lot of confusion as can be seen here. The FED simply does not have much control over the general money supply growth, which is what the articles discussed correctly.

Edit 2
Even though it was claimed I spent too much time it seems it wasn’t enough to make clear what the charts display. It’s normalized, as explained in the text (normalized to Dec 2005 = 100 for each series), visible in the code I provided (if you know basic coding in any language, you can read [mb.data.value[start:ends,:]./mb.data.value[start]*100), as well as the legend. MB stands for monetary base (red), M1 is yellow and M2 is green. The dot in front of the right division operator is a convenient way for data formatting called broadcasting (vectorizing a function).

It is common to normalize levels to facilitate comparison. For example, Paul Krugman does it here, and the Divisia money aggregates also use this logic (more on them below). You can however already see in their charts that QE and zero rates did little to money growth, which actually declined for quite some time after the subprime crisis.

With regards to:

“You seem to be arguing against straw man argument that Fed directly sets M2 which is something nobody ever argued Fed does, argument is whether fed controls (i.e. is able to affect evolution of thereof) of monetary aggregates (not just M2), that is the main argument that your answer ignores.”

Firstly, the GMO research written by Montier and Pilkington references a CNBC article. Now that article in turn references Morgan Stanley research where Mike Wilson, CIO and Chair of the Global Investment Committee made that statement – which in turn was directly referencing M2. Insofar, what concerns the question at hand, M2, as measured by the Fed, is the most relevant of all monetary aggregates. As shown in my charts, M2 and M1 changed little, if at all, when the FED conducted several rounds of QE and cut the FFR to near zero. In the words of Ben Bernanke’s October 8, 2009 speech on the Fed’s Balance Sheet

“Currency and bank reserves together are known as the monetary base; as reserves have grown, therefore, the monetary base has grown as well. However, because banks are reluctant to lend in current economic and financial circumstances, growth in broader measures of money has not picked up by anything remotely like the growth in the base. For example, M2, which comprises currency, checking accounts, savings deposits, small time deposits, and retail money fund shares, is estimated to have been roughly flat over the past six months.”

Interesting side remark, Montier and Pilkington themselves try to debunk that statement by using exhibit 4 and exhibit 5 which show YoY growth rates of M2 and total assets of the banking system as well as the various components of these total assets. They go on to claim that the expansion has been due to reserves (which are essentially base money). Hence, the FED controls money supply according to the authors. What is missed, or ignored, though is that except for the latest surge, total assets as well as money supply growth actually declined when reserves increased ( which can even be seen in the two exhibits).

With regards to setting M2; well, that was the monetary aggregate of choice by Milton Friedman, the world’s best- known “monetarist”, who was a strong advocate of controlling the rate of growth of the money supply. In his defense, despite his advocacy on the official simple- sum M2 monetary aggregate, he was well aware of the inherent problems with the official monetary aggregates. Friedman, coauthored by Anna Schwartz (1970, pp. 151–52) published, in their landmark book on United States monetary history, the following statement:

This [simple summation] procedure is a very special case of the more general approach. In brief, the general approach consists of regarding each asset as a joint product having different degrees of “moneyness,” and defining the quantity of money as the weighted sum of the aggregated value of all assets, the weights for individual assets varying from zero to unity with a weight of unity assigned to that asset or assets regarded as having the largest quantity of “moneyness” per dollar of aggregate value. The procedure we have followed implies that all weights are either zero or unity. The more general approach has been suggested frequently but experimented with only occasionally. We conjecture that this approach deserves and will get much more attention than it has so far received.

A lengthy footnote to that statement lists the PhD dissertations of Friedman’s students who attempted to produce weighted sums of monetary assets. However, they did lack the tools without knowing index- number theory or aggregation theory that were developed later by Diewert (1976) who unified index- number theory with aggregation theory. The literature on rigorous monetary-aggregation theory and subsequently monetary index numbers began with Barnett (1980) in the Journal of Econometrics.

Henry Simons, also American, and Friedman’s teacher at Chicago, wrote in an essay called “Rules versus Authorities in Monetary Policy” that

The existence of near-moneys makes control of any monetary aggregate a futile exercise.

He based this on the idea that any operational definition of money is necessarily arbitrary, meaning that there will always be a bright line between what is money under the definition and what is not money.

Either way, neither Simons nor Friedman had access to the tools developed to compute state of the art monetary aggregates. William A. Barnett (1984) published figures for Simple Sum monetary aggregates and Divisia aggregates in the American Statistician, which is a publication of the American Statistical Association. The reason for this publication was the nonborrowed reserves policy applied under Paul Volker from October 1979 to September 1982, which was frequently dubbed the “Monetarist Experiment”. The recession that followed was widely viewed as being particularly deep and unintended in size. Barnett argues that faulty money supply aggregates were the cause and summarizes it as follows:

“The simple-sum aggregates’ growth rates were at the intended levels, but the Divisia growth rates were half as large, producing an unintended negative shock of substantially greater magnitude than intended. A deep recession resulted”.

In case some readers don’t know what Divisia growth rates are, I recommend looking at the center for financial stability as a start (as mentioned, levels are also normalized like my charts above). For short, a Fisher ideal index (or Fisher Price Index) is a geometric average of the Laspeyres Price Index and the Paasche Price Index. It is deemed the “ideal” price index as it corrects the positive price bias in the Laspeyres Price Index and the negative price bias in the Paasche Price Index. In practice there is little difference between the Fisher ideal and the Divisia monetary indices proposed by Barnett.

You can read here to see what some very highly regarded economists and policy makers have to say about a book Barnett wrote about the lack of proper measurement and hence control of monetary aggregates of the FED. So measurement errors (which are sizable in conventional M2 for example) make it harder to influence money aggregates in a desired way, which is intensified by the fact that private banks are the main drivers of M2 levels and growth rates according to Bernanke (and anyone who knows how accounting works). In case you have access to Bloomberg, ALLX DIVM<GO> shows all Divisia money aggregates.

Now, the Fed currently doesn’t pay much attention to monetary aggregates in any case. So anyone worried that rising levels in M2 (or any monetary aggregate not directly controlled by the FED) will result in inflation, is worried that the Fed will be too slow to react before it is “too” late (for whatever level of inflation whoever is concerned is worried about). If M2 is impacting inflation itself is another (potentially equally less understood) question.

Ignoring all of the above, exact technicalities of monetary policies implemented across the globe are a lot more complicated than any (under)graduate textbook I have read admits.
Starting with the Fed, traditional quantity adjustments are determined via a two-step procedure:

• first the interest-rate target is determined by a monetary policy committee (the FOMC in the US) disregarding the size of the implied open-market operations,
• afterwards, it’s mainly the trading desk at the New York Fed determining the appropriate daily open-market operations necessary to maintain the funds rate near the target (because traders better understand the financial markets) Insofar, it’s not even clear what the impact on money supply will be exactly when rates are set.
  
  

More importantly, in a general sense, several central banks like the ones in countries like Canada, Australia, and New Zealand implement monetary policy through a combination of a lending rate and a deposit rate, which together define a channel within which overnight interest rates should remain. These are both standing facilities (unlike the Fed’s discount window in the United States) which results in the central bank being able to control overnight interest rates within a fairly tight range regardless of the aggregate supply of clearing balances. Consequently, frequent quantity adjustments are a lot less important. Thus achievement of the central bank’s operating target does not require any quantity adjustments through open-market operations in response to deviations of the market rate from the target rate; nor are any changes in the supply of central-bank balances required when the bank wishes to change the level of overnight interest rates. Anyone interest in more details can read an excellent intro in Michael Woodford’s Interest and Prices on P.26 onwards.

Goodfriend was the first within the Fed, to my knowledge, to publicly discuss the potential to manage productively the aggregate quantity of broad liquidity in the economy independently of interest rate policy. While this does not mean that the Fed cannot control money supply, it shows that it is not tied to interest rate policies. Now, the FED began paying interest on reserves in October 2008. Banks earning interest on their reserves have no incentive to lend at interest rates lower than the rate paid by the central bank. For this reason, the central bank can adjust the interest rate it pays on reserves to steer the market interest rate toward its target level. With this background, Goodfriend (2009) proposed a new way of classifying a central bank’s policy tools. In his terminology, monetary policy refers to changes in the monetary base (reserves plus currency in circulation) while interest rate policy refers to changes in the interest rate paid on reserves.

There is an important question as well, namely, can the Fed be sure to have sufficient interest income to finance independently whatever interest must be paid on reserves as the economy emerges from the zero bound? For example, if the Fed acts too slowly against inflation, negative cash flow problems could arise if the Fed has to raise interest on reserves above long term interest rates to stabilize inflation. This was pointed out by the National Bureau of Economic Research (NBER) and Goodfriend, and can be read at the Atlanta Fed website.

With regards to:

“I never seen someone invest so much into proving something that is based on misunderstanding English.”

First of all, up until this arguably lengthy edit, what was done was mostly Ctrl+F and Ctrl+C/V from Romer, which in total took about 15 to 20 minutes. There were very few lines of code, but we use charts like these constantly at work anyways, meaning it took about 3 to 5 minutes to produce these. The rest is not longer than any other answer here.

Claiming I have a misunderstanding of English is odd at best.

• David Romer is American. As pointed out above, he wrote: “measures of the money stock that are sometimes closely linked with aggregate demand, such as M2, are difficult for the central bank to control.”
• Paul Krugman is also American. He wrote a NY times blog called “The Fed Does Not Control the Money Supply”. While his argument is for the opposite case (the zero bound), the main worry in the NBER & Goodfriend research cited above is that the zero bound required extraordinary large increases in the monetary base to be affective, which in turn may make unwinding it hard because negative cash flow problems could arise.
• Mike Finnegan is American, and wrote the FED article that claims: “ the Fed controls inflation by controlling the interest rate on excess reserves. Thus, an increase in the monetary base no longer necessarily leads to an increase in the money supply.” The current worry is the opposite, but either way it is not guaranteed and easy.

So coming back to the actual question about the headline that the

Fed may not be in control of Money Supply growth, which means they won’t have control of inflation either.

That was MS research specifically talking about M2. It is undisputed that a central bank has the monopoly when it comes to creating base money. However, the concern of the authors (and some others) is that the FED will find it hard (harder than the FED believes) to reduce economywide money supply effectively once it is needed. The much cited McLeay (and other spellings which I suppose refer to the same article) also writes in the very first sentence that

The majority of money in the modern economy is created by commercial banks making loans.

Not that it makes any difference, but McLeay et al. were not the paper that debunked the money multiplier. This was discussed before by others like Paul Sheard and several central banks do not use reserve requirements in the first place (see IMF 2011 for a list where the authors also state that the money multiplier approach does not reflect modern central banking practice).

While ultimately the central bank could in theory reduce money to zero, practically controlling monetary aggregates in a sensible way is difficult because central bank policies only indirectly affect these. One of the charts chart shows that M2 relative to MB went from above 9x to well below 3x of MB and M2 literally hardly changed it's trajectory during all phases of QE and zero rate environments.

Anyway, that's probably more text than anyone needed but I couldn't resist.

Answer 4

Edit: Econ Primer - The Feds New Monetary Policy Tools

This 11 page paper, published by the Federal Reserve Bank of St. Louis, describes how the Fed controls the level of bank reserves and the interest rate on federal funds before and after 2008:

https://files.stlouisfed.org/files/htdocs/publications/page1-econ/2020/08/03/the-feds-new-monetary-policy-tools_SE.pdf

In this paper there is no mention of the mechanism by which Fed controls the money supply under either monetary policy regime.

In the Limited-Reserves framework the supply of reserves in the fed funds market would be determined by conditions in the money markets and by Fed intervention to keep control of the fed funds rate (FFR). In this scheme either Fed provides all the required reserves and excess reserves necessary or it would lose control over the fed funds rate. Two stories can be told about this system. 1. By using reserve requirements to restrict growth of money supply Fed can control the money supply but then it would have no control over the fed funds rate. 2. If banks can actively develop liabilities not subject to reserve requirements then Fed either has to impose strict regulations to close this loophole or else Fed cannot even control the money supply because it is a residual liability driven by bank liability management activities.

In the Ample-reserves framework the reserve requirements are no longer relevant to an analysis of the fed funds rate. Instead Fed pays interest on excess reserves at the IORB rate to keep banks from making efforts to purchase short term Treasury bills or making fed funds loans to other banks as shown in Figure 4 of the paper.

Simplified Aggregate Bank Balance Sheet

$$\begin{array}{|c|c|} \text{Assets} & \text{Liabilities} \\ \hline \text{Reserves} & \text{M2 Deposits} \\ \hline \text{Loans} & \text{Borrowings} \\ \hline \text{Securities} & \text{Equity} \\ \hline \end{array}$$

M2 Deposits = Reserves + Loans + Securities - Borrowings - Equity

Banks do not control the level of M2 Deposits in the money supply because this level changes as follows. When banks issue net new loans or purchase more securities this tends to increase M2 Deposits. When banks issue net new borrowings or net new equity this tends to decrease M2 Deposits. This means banks do not control the level of M2 money supply. Borrowings include items such as deposits not counted in M2, repurchase agreement (repo) liabilities, eurodollar borrowings, borrowing from Fed, long term debt, etc. If a bank cannot attract M2 deposits it looks to other sources of borrowing to carry its portfolio of loans and securities in the liquidity cushion.

Simplified Fed Balance Sheet

$$\begin{array}{|c|c|} \text{Assets} & \text{Liabilities} \\ \hline \text{Securities} & \text{Reserves} \\ \hline \text{Loans} & \text{Other} \\ \hline \text{} & \text{Equity} \\ \hline \end{array}$$

Reserves = Securities + Loans - Other Liabilities - Equity

Note M2 Deposits do not appear on the Fed balance sheet. When Fed purchases securities or issues net new loans to a non-bank counterparty the payment is cleared by banks. These transactions tend to increase the level of Reserves and also the level of M2 Deposits. However the banks and non-bank investors then have the ability via market transactions to convert levels of M2 Deposits into Borrowings and Equity as shown in the aggregate bank balance sheet. The level of M2 Deposits is a mere residual.

Note when Fed increases assets, and the counterparty is a bank, then these transactions increase Fed assets and Reserves but do not directly impact the level of M2 Deposits in the aggregate bank sector.

Because the financial market activity of banks and non-banks impacts the level of M2 Deposits as a residual over time no government or private institution has control over the level of M2 Deposits.