Which Is More Important For Monetary Policy: The Growth Of The Fed’s Balance Sheet Or Its Level?

In my previous post, I noted that the FOMC has apparently begun to think of its low interest rate policy and its quantitative easing/balance sheet expansion policy as two different things. Their latest minutes suggest sentiment by some members for slowing or ending the announced open market purchases by the end of 2013, or possibly even sooner. There was no suggestion, however, that doing so would bring their accommodative monetary policy (low interest rates) to an end. I suggested that, if those two things can be treated separately, then it would be better to do the opposite: allow interest rates to rise a bit while keeping quantitative easing adequate to provide continued growth in the money and credit aggregates. The latter would continue support for the fragile economy while the former would provide relief for savers who have suffered minimal interest rates for over four years now.

I later realized that my suggestion for keeping QE active enough to support the economy highlights a difference in the way I’ve always thought about monetary policy and the way Chairman Bernanke thinks about it. Using the equation of exchange (MV=PQ) as a framework, the way I learned it was that to keep P (the price level) relatively constant, you need MV to grow at about the same rate as Q (real output) is capable of growing. Faster risks inflation; slower risks deflation or recession. If V (velocity of money), which is a reflection of the demand to hold money balances, is stable, then the growth in M should match the potential growth in Q. If V is not stable, but is predictable, then M growth can be adjusted to accommodate V’s change. The bottom line is that to keep the real economy growing at or near its potential money should grow at about the same rate. Precision is unlikely, but at least money needs some growth to prevent a drag on real growth.

The implication of my view of the way monetary policy works for the assets of the Fed is that the current level of total assets is a result of past policy and that continued slow growth is needed to support the real economy going forward. Obviously, if banks start utilizing their excess reserves more aggressively to make money-creating loans and investments too rapidly, then partially offsetting open market sales would be needed. Likewise, if the velocity of outstanding money picks up substantially, a similar offset may be needed. However, if neither of these things happens, I see no reason to stop open market purchases entirely. To do so would represent a sharp tightening of monetary policy.

That, however, is not the way Chairman Bernanke views the role of the Fed’s balance sheet. On many occasions, he has said that it is the level of the assets on the Fed’s balance sheet that determines the stance of policy rather than their rate of growth. Consequently, he believes (as I interpret him) that, if the balance sheet stopped growing at some point, the existing degree of ease at that point would continue. He apparently does not believe, as I always have, that a flow of new money is necessary to sustain real growth as long as the stock of money doesn’t shrink.  He believes that the size of the Fed’s balance sheet is what’s important. I don’t understand his reasoning, but I freely acknowledge that he is not only smarter than I am, but that he is much more familiar with recent literature on the subject. His views have been aired among high-level academics at Jackson Hole among other places and survived.

My point in bringing this up is that it does lend credence to the idea that the FOMC may slow or stop growing the balance sheet sooner rather than later. The Chairman, for one, would not consider that a tightening of monetary policy, especially if interest rates remained low. That does not change my view that, if QE and interest rate management are separate things, it would be better to give savers some relief by allowing interest rates to rise a bit. It is helpful, however, to get over the idea that interest rate targeting precludes a range of possibilities in open market operations.


Comments (2)

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  1. Kyle says:

    I suppose that Bernake doesn’t send out Green Book forecasts in an online newsletter?

  2. Gabriel Odom says:

    We can actually translate this question into a physical scenario.
    Which is more scary: a baseball flying at you (the growth of the Fed’s balance sheet), or a grand piano hanging above you on a rope (the level of the Fed’s balance sheet). The baseball has kinetic energy – energy from movement. The growth rate of the balance sheet is akin to the speed of the ball – the higher the growth rate, the higher force of impact the growth rate has on the economy. People will catch a slower-moving ball, but get out of the way of a fastball. Thus, the velocity of money does influence the behaviour of the consumers and producers. People will live with a lower growth rate, but will react quickly to a higher growth rate.
    However, the question is not whether the Fed can influence the economy, but rather how strong that influence is.

    Consider the hanging piano. This object’s potential energy is immense, and possibly incredibly devastating. When the Fed holds a great deal of assets on the balance sheet – corresponding to the amount of liquid money drawn from the economy, producers and consumers are aware of the potential effects that the balance sheet can have. This may decrease producer and consumer confidence, which in turn decreases the consumers’ willingness to spend money. This effect was described by the late Paul Samuelson: “You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs.” (Economics (1948), p 354) The rope holding the piano will not keep forever; similarly, the size of the Fed’s balance sheet cannot hold in the long run. This is simply Ricardian Equivalence applied to the Federal Reserve – those assets have to move eventually. The greater the level of the Fed’s balance sheet will be directly related to consumers’ fears for the economy. As long as the balance sheet remains fat, people will worry about the health of the economy. This is a longer lasting, and potentially more powerful effect, than the rate of growth of the balance sheet alone.