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Why Monetary Stimulus Is Broken

I am trying to understand the broken transmission vectors for monetary policy. It is clear that the gearboxes between the monetary base and the money supply and between the money supply and NGDP are stuck in low gear, and that the more that the Fed pushes, the lower the gearing goes. We are stuck in first gear, whereas we should by now be in at least third gear. Something is wrong.

Two gearboxes are broken: the one between the monetary base and the money supply, and the one between the money supply and nominal growth.

Let’s start with the first gearbox: the one between MB and M2 (M2/MB). The Fed has bought truckloads of bonds from the banks, creating massive free reserves ($2T) that should be used to fund loans. Instead, the banks are keeping these excess reserves on deposit at the Fed. Why? Well, for one thing, reserves pay .25% but attract a zero capital coefficient. That is a .25% return on nothing, which is attractive in a world where 1% is high yield. (Memo to Ben: the yield on excess reserves should be zero.) Another reason is that Dodd-Frank and Basel are imposing higher capital ratios on the banks, which makes it very expensive to grow loan books. (I am in total agreement with Dodd-Frank on this, but it’s timing is inopportune; it should have happened before the Crash.) So right now, banks are happy to have huge deposits at the Fed, which means that they are liquid and feel good about themselves. But this also means that the Fed is pushing on a string when it creates free reserves: the credit transmission vehicle is broken. And the credit aggregates bear this out. While private sector credit growth is no longer in reverse, it remains stuck in first gear: “No Cash for No Body”, as the Texans used to say. The good news here is that the trend-lines have now inflected and we should see household and corporate credit starting to grow (fingers crossed).

Next we come to velocity, the V in the quantity theorem (NGDP/M2). We appear to be stuck in what Keynes called the liquidity trap, when monetary stimulus loses its power because of diminishing returns (V goes down as M goes up). Why has V been declining since the Crash? V is the liquidity preference, the desire to hold liquid cash. There are two cohorts to consider: households and corporations.