The curious failure of the Money Multiplier effect and Ben Bernanke’s likely legacy

A few years after the Federal Reserve cut  key interest rates to record low levels, and having implemented three massive cash injection programs in order to provide liquidity to the market, it seems an appropriate  point to look into the real and lasting  effects on the US economy.

At a first glance we can see that the  worst of the mortgage crisis is already behind the world’s number one economy and the housing market  appears to have been stabilised as there are  no liquidity issues  anymore with unemployment and growth rates now moving smartly away from their credit crunch levels. However, many observers would also add that this resurgence has been happening in “slow motion”. The recovery has been frustratingly pedestrian, which is in sharp contrast to the rapid expansion of the US monetary base and the FED’s balance sheet. For such an epic use of unconventional measures, which have inflated the FED’s balance sheet into the trillions of dollars,  the final outcome falls short of many people’s expectations. With the US economy now out of crisis, and with the asset-purchase program being relatively ineffective, we are forced to wonder why is the FED persisting with it? And why is it failing?

The first signal that something is wrong comes from the current inflation rate in the USA. The monetary base of the USA  has grown  from $800 billion to over $3.2 trillion in just a matter of a few years! Given that expansion in inflation, America should have skyrocketed. It’s simple maths.

The Fed buys Treasuries and MBS, injecting money into commercial banks, and which can then proceed to lend to households and companies. With trillions on their hands, banks can lend out ten times their reserves, as they are only required to keep a small fraction of these. Basically they’re able to transform M0 into M2, with the ratio between the two aggregates roughly being the money multiplier. Traditionally this ratio has been around 10 in the US.

Now let’s look at M0 the narrowest gauge of the money supply. Banks could in theory have multiplied the growth in this measure of $2.4 trillion into $24 trillion (the prior number represents the difference between $3.2 trillion of M0 now and the $800 billion it stood at before intervention began). If that were to have happened, a coffee could now cost $25 or more as inflation would have exploded. Fortunately for you and I it didn’t happen! But why not ?

The answer is that something failed between M0 and M2, and it was the multiplier. To demonstrate this, we have collected data from the St. Louis Fed database and have  calculated the actual derived money multiplier. See the chart below.

The money multiplier had been relatively stable since the nineties up until August 2008. In that month, the ratio was 8.8, and then it dropped to 8.6 in September, 7.2 in October and 5.8 in November. At the end of 2008, it hit 5.0 and continued declining to the current ridiculous 3.3 value.

In October 2008, Section 128 of The Emergency Economic Stabilization Act of 2008 was approved and allowed the FED to start paying interest on the excess reserves banks hold at the central bank, in addition to the already remunerated required reserves.

These measures  were required to help stabilise an  economy in the grip of a credit crunch and recession. But excess reserves, which were negligible, jumped from $1.9 billion in August, to $59 billion in September 2008, to $767 billion at the end of 2008, and finally to the current $1.87 trillion. Notwithstanding the cost to the American economy  in terms of the interest paid on the $1.87 trillion parked at the central bank, there is something much more important that we need to  consider – namely  the explanation for  the relative failure of  Quantitative Easing .

In order for this newly printed money to be effective as an expansionary tool, banks would have to lend this money and let the multiplier silently do its job. But with the multiplier declining dramatically from 8.8 to 3.3, banks are just parking the money back at the central bank  producing a diminishing return.  So, Ben Bernanke  it doesn’t seem to matter just how much you print, it isn’t having the desired effect!

If the FED was really interested in letting base money flow to the economy, the simplest measure would not be to buy $85 billion in assets per month but rather to cut interest rates paid on deposit or even to turn those rates negative (as we have seen in Switzerland recently) . That way, banks would find it much more interesting to lend to households and businesses, rather than have their money parked at the central bank. But the FED insisted in using its “fireworks” instead and now it may in fact be too late…

Trying to unfold excess reserves would lead to hyperinflation, as there is way too much money parked at the central  bank  in the form of  excess reserves. If the FED stops  its  printing and asset purchase  programs bond prices will  fall dramatically likely, as we have had a taster of recently and thus the banks will then have a real incentive to withdraw that excess money from the central bank. That would be the real monetary easing! However, letting monetary easing measures continue indefinitely also isn’t  the solution, as  overtime people and more importantly the markets will start losing faith in the policymakers and the “soundness” of money. A time will come when yields will rise dramatically…

In our view, the FED has played its hand in full now and there’s no obvious solution to the current problem. The best you as an individual  can do is to buy real assets and avoid holding material amounts of cash. Many, including us, would see Gold and related mining plays as the best long-term bet in relation to this nonsensical  policy.

Just as a final comment, it seems to us that the FED’s real purpose was not to improve the economic situation in the US, but rather to protect the US government from defaulting and losing its reserve status. Its policy was always to keep yields on Treasuries low. As we have seen, changing the deposit rate would have been much more effective in the pursuit of  growth and beneficial to the wider economy. 

Written by Richard Jennings, CFA. Fund Manager, Titan Investment Partners.