Recent Monetary History: A Monetarist Perspective

Abstract

The U.S. Federal Reserve System has recently added very large additional supplies of its own money, in the form of deposits (cash reserves) held by member banks with the Fed. The first injection of central bank money offered in exchange for Treasury Bonds and MBS (QE) was intended to overcome the Global Financial Crisis (GFC) of 2008-09. The second infusion of extra cash was intended to relieve the impact on the economy of the COVID lockdowns of 2020.

The increase in the money base—defined as commercial bank deposits with the FED plus currency in issue—after 2008 did not lead to any acceleration in what had become a very low rate of inflation. Nor did it lead to any notable acceleration in the supply of money, broadly defined. But both the money supply and spending reactions to the additional central bank money after 2020 have been very different. And the growth in the money supply accelerated sharply and, along with it, inflation.

The author explains these different outcomes in terms consistent with the monetarist and quantity theory traditions. A tradition that focuses on the importance of the demand for as well as the supply of money—including central bank money. The article shows that the demand for as well as the supply of cash reserves increased markedly after the GFC, reflecting the worldwide risk aversion and surfeit of capital. The exposed banks were reluctant to lend more and preferred to shore up their leveraged balance sheets holding extra cash which slowed down deposit growth. Banks in the wake of the COVID lockdowns have proved more willing to exchange cash for overdrafts, leading to rapid increases in the supply of deposits and money. Such increases have in turn led predictably to more spending as the extra money was exchanged for goods, services, and assets that caused prices to rise sharply.

To reverse these inflation trends, the Fed will need to control the supply of money and bank lending. To do so effectively, the Fed should attempt to estimate the demand for large (excess) cash reserves of the banking system and set the interest rate it offers on these cash reserves accordingly. But this Fed is not monetarist; it takes little notice of money or bank credit supplies and will continue to rely on its interest rate tool to limit demand. Nevertheless, monetarists and the market will be watching closely how well the Fed manages a transition not only to higher interest rates, but back to non-inflationary increases in the supply of money.