Looking at the Money Supply

Posted by Deepish Thinker on April 26, 2011

The following chart shows the growth in the broad money supply (M2) and BASE money supply as a percentage of M2 over the past 15 years.  BASE money supply is physical currency plus Federal Reserve accounts.  This is the portion of the overall money supply that the Fed directly controls.

Data Source: St Louis Federal Reserve

As you can see, M2 has been growing at a reasonably steady rate for the past 15 years.  BASE made up a reasonably constant proportion of M2 up until the end of 2008.  At that point the Fed had to dramatically increase the BASE money supply in order to keep M2 expanding at roughly the accustomed rate.

There are a number of different ways of looking at this.  It could be that this is simply the new normal and the the Fed’s balance sheet will henceforth make up a higher percentage of the overall money supply than has generally been the case.

Alternatively, you could view the situation as essentially benign.  The Fed’s balance sheet is relatively large because it had to respond to the crisis.  It will shrink over time as the economy recovers.  My guess is that this is Chairman Bernanke’s preferred assessment.

The pessimists among us tend to believe that quantitative easings are a bit like wars in the Middle East.  Much easier to get into than out of.

I’m inclined towards pessimism, or at least skepticism about the existence of free lunches.  The Fed’s extraordinary actions over the past few years may well have taken some of the bite out of the crisis, but my guess is that we pay for them through either inflation or uncomfortably tight monetary policy down the road.

(Data source:  St Louis Federal Reserve)