Money Doesn’t Make America’s Economy Go Around


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Internet memes and pundits alike often display a specific understanding of how the US economy works: that the sheer volume of money is the most important determinant of output and prices. Following their logic, the Federal Reserve’s pandemic-related expansion of the money supply caused today’s inflation, and its current contraction will quickly crush inflation and trigger a recession.

If only the Fed’s job were that simple. Such thinking is wrong, in at least two ways.

First, money supply is just one of many factors that influence the US economy, and its linkage to actual outcomes has always been very tenuous. People’s willingness to borrow, and financial institutions’ willingness to lend, matters as well. The circulation of money — its velocity — depends on the actions of a vast array of financial intermediaries and their customers, of which banks are only a small part. This is all reflected in the famous equation MV=PQ, where M is money, V is velocity and P and Q are the price and quantity of economic output. Knowing M doesn’t help much in predicting P or Q, because V is highly variable.

The Fed has targeted money supply only once, during Paul Volcker’s battle with inflation from 1979 to 1982. Even then, the motivation was primarily political: The imperative of slowing money-supply growth provided cover for Volcker to push interest rates up to previously unfathomable levels. Once inflation was defeated, the Fed quickly discarded money supply as a target.

Second, the Fed’s conduct of monetary policy changed fundamentally in 2008, when Congress granted it the power to pay interest on the reserves that banks maintain at the central bank. The move severed the link between the amount of bank reserves, which is the key input to the money supply), and the price of credit. If, say, the Fed sets the rate on reserves at 5%, banks have no reason to lend for less, no matter how much reserves they have.

This is why inflation didn’t surge amid the Fed’s quantitative easing programs of 2009 to 2014 and 2020 to 2021, even as bank reserves and money-supply growth peaked at more than $4 trillion and 26.9%, respectively. Most of the money just sat there: Despite a glut of deposits that reached some $18 trillion, total bank loans and leases declined from a peak of $10.9 trillion in May 2020 to $10.4 trillion a year later. And now, the fact that banks are awash in reserves and liquidity will also mitigate the effects of the Fed’s quantitative tightening. One reason they’ve been so slow to raise interest rates on customer deposits is that they don’t need to attract more money to fund their lending. 

Where, then, did inflation come from? The economy overheated for several reasons: Shifts in the composition of demand towards goods during the early stages of the pandemic led to supply-chain snarls, fiscal stimulus added to spending power, and the Fed kept interest rates too low for too long. If rates had been considerably higher, earlier, the economy would have grown more slowly, the labor market wouldn’t be as tight and wage and price inflation would be lower. 

So what about quantitative easing? Did it have no effect at all? Of course it played a role in making monetary policy more stimulative by pushing down bond yields and mortgage rates, but its contribution to inflation is vastly exaggerated. Most of the reserves and deposits that it created just sat on the banking system’s balance sheet and were not lent out.

Similarly, quantitative tightening’s impact will be far more modest than the shrinkage of bank reserves and money supply might suggest. What really matters is the level of short-term interest rates (how high for how long), their impact on financial conditions and how this influences people’s willingness to borrow and spend.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics. A senior research scholar at Princeton University, he served as president of the Federal Reserve Bank of New York and as vice chairman of the Federal Open Market Committee.

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