Part 2 to Rising Interest Rates Post Above
The government can increase the funds available that banks and trust companies have to lend when demand is great. This measurement is called the money supply. It is important to watch for strong growth in the money supply which might lead to inflationary pressures as money inflates aggregate demand.
My favorite of the monetary aggregates is the M2 Money Supply. The M2 is the sum of: checking accounts, travelers checks, tender that is held outside banks, savings deposits (this includes money market accounts from which no checks can be written), small denomination time deposits (less than $100,000), and retirement accounts, minus the amount of money in the Federal Reserve float.
The chart above shows that the money supply was shrinking until about mid-2006 when it became apparent that the government began increasing the money supply.
The Three Main Methods the Fed. Reserve Controls the Money Supply
1. The Federal Reserve can control the money supply by changing the reserve requirement. Lowering the reserve requirement increases excess reserves in the system, thereby increasing loan activity. Increasing the reserve requirement decreases excess reserves in the system, thereby decreasing loan activity. Changes in reserve requirements are rarely used to alter the money supply.
2. The Federal Reserve can control the money supply by changing the discount rate. Lowering the discount rate gives depository institutions a greater incentive to borrow, thereby increasing their reserves and lending activity. Increasing the discount rate gives depository institutions less incentive to borrow, thereby decreasing their reserves and lending activity.
3. The Federal Reserve can increase the money supply by purchasing U.S. Treasury securities. The purchase of securities increases the amount of reserves in the system, thereby increasing loan activity.
Because of the ailing housing and manufacturing sectors caused in part by the Fed. using method #2 as listed above, they are now using method #3.
Now as the Fed. realized in mid-2006 that they had to increase the amount of money available for banks to lend as changing the discount rate massively decreased lending activity, they began buying U.S. Treasuries to pump more money into the system. We can pin-point the exact month in which the Fed. began doing this by watching the U.S. Dollar. The reason we can track the M2 in the U.S. dollar is that as the valve opens up as the Fed. increases the number of U.S. dollars in circulation, an unintended negative side effect is that it also reduces the value of the dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services, which in turn is inflationary.
If we compare the U.S. dollar chart above with the M2 chart above, we can see that in mid-October 2006, the Fed. began buying massive amounts of U.S. Treasuries to pump more money into the economy (to counter the rapid slowing associated with the higher discount rate), which diluted the value of the dollar.
The Federal Reserve is buying Treasury bills and bonds to make more money available for banks to loan to reduce some of the effects of higher interest rates.
The danger is that if the financial markets start worrying about inflation and about being paid back in watered-down/diluted dollars (see U.S. Dollar chart above). This concern may lead them to start dumping their holdings of U.S. Treasuries. In so doing, they'll drive up interest rates, which will lead the Fed to print money to buy up those bonds. The consequence will be more money creation – exactly what the bond traders will have come to fear. This could lead to spiraling expectations of higher inflation, with the process eventuating in hyperinflation according to Prof. Laurence Kotlikoff of Boston University.
The Fed. realizes this and is why in every Fed. Minutes release you read about Bernanke talking about the threat of inflation. Some ignorant market participants might state, "Oh, Bernanke's just an inflation hawk", and dismiss his mentioning of the threat of inflation. Now that you have read this article, you should understand that this is an overly simplistic stereotype or generalization of Bernanke because when you understand the money supply and what the Fed. is currently doing, you also come to understand with greater appreciation the terribly horrific power of inflation.