The Monetary Base vs. the Money Supply

The adjusted monetary base keeps exploding.  The last 5 years has been unprecedented.  We really are in uncharted waters.

As you can see, the total monetary base is now almost $3 trillion.  It was slightly over $800 billion before the fall of 2008.  If the Fed keeps expanding at its current pace for another year, it will hit $4 trillion.  That means that the monetary base will have grown by five times in less than 6 years.  As of right now, it is almost 4 times what it was.

Yet we haven't seen exploding consumer prices.  The stock market has been going up and you can certainly see subtle price hikes at the grocery store and gas station.  But there is no question that the price inflation has not matched the monetary base.  So what is going on here?

We have to look at another thing that has been unprecedented in the the last 5 years.  Commercial banks have not been loaning out the amount of money that they are allowed to loan out.

The banks have reserve requirements.  In the U.S., the reserve requirements have generally been around 10% in recent history.  This means that banks can loan out up to 90% of deposits.

If someone deposits $1,000 into a checking account, the bank would loan out about $900.  Now a person or company has $900 and puts it in his bank.  His bank then lends out $810 of this, while keeping 10% on reserve.  The process continues, which effectively multiples the money supply in the system by almost 10 times.  So the original $1,000 deposited into the bank becomes almost $10,000.  Even though not everyone can get their money at once, it has the appearance that all of this money is available, and people and businesses act as though it is all available.

This whole system takes place because of a lack of free enterprise in banking.  The banks, particularly the big banks, are supported by the FDIC and the Fed.  This is what enables the banks to take these crazy risks and it keeps depositors from worrying about which bank has their money and what they are doing with it.

In the past, banks would lend out most of the money it was allowed to loan out.  If it was short on its reserve fund when all of the checks cleared on a given day, it would borrow overnight money.  It would pay the federal funds rate, which is usually controlled by the Fed.  However, with the massive excess reserves, most banks don't need overnight borrowing now.  That is why the federal funds rate has been below .25 percent since 2008.

So most of the new money that the Fed has created has gone into excess reserves in the banks.  Banks have not been using the fractional reserve process to multiply the money supply like it has in the past.  This has helped to keep a lid on price inflation.

Let's use some nice round numbers just so we can see what we are dealing with.  The monetary base in 2008 was just over $800 billion.  We will say it was $800 billion.  The banks loaned out about $720 billion, which turned into $7.2 trillion.  You can add in the $80 billion in reserve.  This would equate to about $7.3 trillion.

Now the Fed has increased the monetary base by $2.2 trillion.  But the excess reserves have also gone up, by at least $1.7 trillion.  That means that the banks have only loaned out a small percentage of the new money created in the last five years.  It has kept down the fractional reserve process of multiplying the money supply available.

For the sake of argument, let's say that all $2.2 trillion had been kept in reserve.  From our original estimate, it would have increased the available money supply to $9.5 trillion (7.3 + 2.2).  This is still a 30% increase over 5 years, but it is far less devastating than what the almost 300% increase in the monetary base shows.

So while the massive increase in the monetary base does add to the available money supply and eventually to price inflation, its bad effects have been somewhat minimized, at least up until now, because banks have chosen to build up massive excess reserves, and consumers and businesses have chosen not to borrow as much.

In conclusion, we must continue to watch both the adjusted monetary base and the bank excess reserves.  This will help us be more aware of the looming threat of severe consumer price inflation.