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 However, speaking of money multipliers in the US is outdated.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".
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."
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:
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
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")
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.
size = (800,500),
legend = :topright,
title = "Does the Fed really control the money supply? \n M2 Money Stock / Monetary Base",
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.
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.
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.
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
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.