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January 3, 2014

MICHAEL HICKS: The Fed's year-end actions

Why isn't monetary growth having effect?

The Federal Re-serve’s decision last week to ease its efforts to stimulate the eco-nomy were widely expected, though I thought they might wait another month until the new Fed chairwoman, Janet Yellen, took over the helm. What was unexpected about the announcement was just how minimal the changes were.

To remind readers, the Fed is now actively engaged in something known as QE3, or the third round of quantitative easing. This involves buying government bonds and mortgage-backed securities from banks. That process injects $85 billion each month directly into the economy.

According to a traditional money multiplier analysis, the effect on the actual money supply ought to be equal to $85 billion divided by the reserve requirement of banks, which is less than 2 percent. So, $85 billion divided by 0.02 is $4.25 trillion in additional money per month if banks were to lend it out. Over 2013 that is more than $51 trillion in “potential” new money created by the QE3. This is more than three times the size of the U.S. economy and more than nine times the money we need for transactions each year.

I apologize if you are scared by the math, but, trust me, it is the number of zeros that is the most terrifying. Clearly that growth in the overall money supply is not following this simple money multiplier. We know this because we still have low inflation. The challenge is that this transmission mechanism of the Fed’s monetary policy to the overall economy is weak. With this persistent problem continuing it hardly matters whether the size of the QE3 is $75 billion or $85 billion a month. The question is simply, why is this level of monetary growth not having a more visible effect?

To explain it simply, businesses borrow money to buy capital equipment, from which they can expect a rate of return. If the market interest rate is beneath the rate of return for this capital then borrowing makes sense. If the market interest rate is above the rate of return on this capital than businesses will not borrow. Thus, the Fed depends upon the actual rate of return on capital, which economists term the natural rate of interest.

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