Marginal Revolution reports that interpreting the monetary base under the new monetary regime.
(emphasis mine) [my comment]
Interpreting the Monetary Base Under the New Monetary Regime
By Alex Tabarrok
The monetary regime has changed and, as a result, many people are misinterpreting the recent increase in the monetary base. Paul Krugman, for example, posts the picture
at right. His interpretation is that the tremendous increase in the base shows that the Fed is trying to expand the money supply like crazy but nothing is happening, i.e. a massive liquidity trap [Wrong]. (Krugman is not alone in this interpretation, see e.g. this post by Bob Higgs). Thus, Krugman concludes, Friedman was wrong both about monetary history and monetary theory. [Sigh... again completely wrong]
Krugman's interpretation, however, neglects the fact that the monetary regime changed when the Fed began to pay interest on reserves. Previously, holding reserves was costly to banks so they held as few as possible. Since Oct 9, 2008, however, the Fed has paid interest on reserves so there is no longer an opportunity cost to holding reserves. The jump in reserves occurred primarily at this time and is entirely under the Fed's control. The jump in reserves does not represent a massive attempt to increase the broader money supply.
Here's a bit more background. When no interest was paid on reserves banks tried to hold as few as possible [See *****US Banks Operating Without Reserve Requirements***** for more info on the lengths banks went to avoid reserve requirements]. But during the day the banks needed reserves - of which there were only $40 billion or so - to fund trillions of dollars worth of intraday payments. As a result, there was typically a daily shortage of reserves which the Fed made up for by extending hundreds of billions of dollars worth of daylight credit. Thus, in essence, the banks used to inhale credit during the day - puffing up like a bullfrog - only to exhale at night [Nice example]. (But note that our stats on the monetary base only measured the bullfrog at night [Interesting bit of info].)
Today, the banks are no longer in bullfrog mode. The Fed is paying interest on reserves and they are paying at a rate which is high enough so that the banks have plenty of reserves on hand during the day and they keep those reserves at night. Thus, all that has really happened - as far as the monetary base statistic is concerned - is that we have replaced daylight credit with excess reserves held around the clock. The change does not represent a massive injection of liquidity and the increase in reserves should not be interpreted as evidence of a liquidity trap.
My reaction: Alex is right that people are misinterpreting the recent increase in the monetary base, and he is also right that paying interest on excess reserves is key to understanding what is going on. However, his argument is incomplete.
Once the fed started paying interest on excess reserves, the line between treasuries and reserves became blurred. In addition to being cash deposits redeemable on demand, excess reserves also became an interest bearing asset.
In fact, interest paying excess reserves are currently the most attractive, low risk asset available. The next best thing would be the 1 month treasury, which is (currently) inferior in every way. Although small, 1 month treasuries have default risks and interest rate risks. In comparison, excess reserves have zero default risk and (currently) pay higher a higher interest rate. This can be seen in the graph below.
As long as interest rates stay below the .25%, excess reserves will remain the preferred short term investment of depository institutions. Right now, excess reserves should be considered sterilization bills (like those sold by China to control money supply). It would therefore be more accurate to think of excess reserves as 800 billion worth of short term treasuries (and part of our national debt) rather than part of the US monetary base.
However, if interest on the one month treasury starts rising above the .25% paid on excess reserves, the situation changes. A higher yielding one month treasury would become a more attractive alternative to excess reserves and banks would start turning to them as their preferred short term investment. This would quickly lead to money printing.
Once one month treasury yields start heading up, the fed will have three choices, all of them bad:
1) Do nothing. This would quickly lead to printing, because a higher yielding one month treasury would become a more attractive alternative to ex cess reserves and banks would start turning to them as their preferred short term investment.
2) Raise the interest rate paid on excess reserves. This would temporally keep excess reserves as the most attractive short term investment, but would become increasingly expensive as short term rates climb.
3) Buy short term treasuries to keep rates below .25 percent. This would undermine confidence in the dollar by expanding the fed's balance sheet and would lead to the monetization of the US national debt.
About the velocity of money
Several people have asked what excess reserves imply about the velocity of money. However, I don't believe that really applies here. As I said above, as long as excess reserves are paying more than 1 month treasuries, they should be considered part of the US's national debt, not money supply.
The day when short term rates head up is getting closer. Already, long term rates are beginning to break upwards.