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Summary: The Federal Reserve’s influence on the money supply and interest rates does not seem to match reality.

Introduction

Several years ago, I put together a series of graphs to demonstrate the differences in the Federal Reserve’s influence on money supply and interest rates during the tenures of three Fed Chairmen — Paul Volcker, Alan Greenspan, and Ben Bernanke. I decided it would be informative to republish those graphs.

I considered updating the graphs but chose not to for a couple of reasons. First, the Fed no longer tracks the MZM measure of the money supply. (I used MZM at the time because I felt it provided the best measure for financial instruments actually used as money.) Second, I only wish to make generalized points that do not require up-to-the-minute data.

I present this information more to encourage you to question what you hear on the news about The Fed than to draw any specific conclusions.

Volcker

Paul Volcker has the reputation as the Fed chair who broke the back of inflation during the 1980s. I question whether this reputation is well deserved.

MZM v. Reserves

[Please note that the scale for the money supply is on the left side of the chart, while the scale for bank reserves is on the right. I separated these two because the money supply was about 400 times the amount of bank reserves. I wanted to show trends more than specific amounts.]

During the first half of Volcker’s tenure, bank reserves trended lower, but the money supply continued to grow. During the second half, the quantity of bank reserves accelerated, yet the money supply continued on its historical upward trend.

Interest Rates

The Fed funds rate fluctuated wildly during the early part of Volcker’s term. Almost no correlation existed between the Fed funds rate and the 10-year treasury rate.

During the second part of Volcker’s tenure there appeared to be more of a correlation between the Fed funds rate and the 10-year treasury rate. I will leave it up to you to determine whether changes in the Fed funds rate preceded or followed the 10-year treasury rate.

Greenspan

Many people still believe that Alan Greenspan fueled massive inflation. I will leave that up to you to decide.

MZM v. Reserves

During Greenspan’s tenure, the total amount of bank reserves trended lower—his tenure began with reserves of about 60 billion and ended with reserves of about 50 billion. During that same period, the money supply continued to grow.

These trends tend to contradict normal thinking that decreasing bank reserves should cause a decline in the money supply. One of many reasons this counterintuitive effect arose was the change in the reserve requirement. In 1992, the requirement was reduced to 10%. (To put these reserve requirements in perspective, in 1970, the requirement was 17.5%, and in 1980 it was 12%.)

Interest Rates

Many people believe that the Fed funds rate provides the base for all market rates. If that were true, you would expect a high correlation between the Fed funds rate and the 10-year treasury rate. However, I see little correlation between the two rates in the chart below. Again, I leave it up to you to determine which rate precedes the other.

Bernanke

Ben Bernanke’s tenure is marked primarily by The Fed’s response to the financial crisis of 2008.

MZM v. Reserves

This period was marked most significantly by the massive increase in bank reserves beginning in 2008. Someone coined the phrase “quantitative easing (Q E)” to describe this phase. As a few people have noticed, the money supply subsequently did not explode as one might expect. In fact, growth of the money supply actually slowed after quantitative easing.

I contend that quantitative easing had little to do with expanding the money supply. It was a backhanded method for strengthening the capital requirements of member banks. The capital requirements for banks depends on the quality of the assets they have in their portfolio. By extracting many of the questionable assets on bank balance sheets, the Fed made banks look sounder than they actually were.

[Again, note the different scales for Money on the left and reserves on the right. The relationship is about 10 to 1 – money to reserves.]

Interest Rates

When bank reserves increased dramatically because of quantitative easing, the amount of excess reserves no longer created a limit to money creation by banks. Because of large excess reserves, banks no longer had any motivation to borrow in the Fed funds market, and as a result, the rates fell to near zero.

Because banks became far more selective in the assets they bought, they were more inclined to buy 10-year treasuries than to buy more mortgage notes. This caused the 10-year treasury rate to fall, but nowhere near the rate reflected by the Fed funds rate. Again, little correlation exists between 10-year treasuries and Fed funds.

Conclusion

I conclude this article with two simple questions:

What role does the Fed play in the creation of money?

How much influence does the Fed have on long-term interest rates?

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Chairman Tenures

For your information, I have provided a table of the tenures of all Fed Chairmen from the first through Jay Powell.

The Federal Reserve Chairmen

Chairman	Term
William Gibbs McAdoo	December 23, 1913 – August 10, 1914
Charles S. Hamlin	August 10, 1914 – August 10, 1916
William P. G. Harding	August 10, 1916 – August 9, 1922
Daniel R. Crissinger	May 1, 1923 – September 15, 1927
Roy A. Young	October 4, 1927 – August 31, 1930
Eugene Meyer	September 16, 1930 – May 10, 1933
Eugene R. Black	May 19, 1933 – August 15, 1934
Marriner S. Eccles¹	November 15, 1934 – February 3, 1948
Thomas B. McCabe	April 15, 1948 – April 2, 1951
William McChesney Martin, Jr.	April 2, 1951 – February 1, 1970
Arthur F. Burns	February 1, 1970 – January 31, 1978
G. William Miller	March 8, 1978 – August 6, 1979
Paul A. Volcker	August 6, 1979 – August 11, 1987
Alan Greenspan²	August 11, 1987 – January 31, 2006
Ben Bernanke	February 1, 2006 – January 31, 2014
Janet Yellen	February 3, 2014 – February 3, 2018
Jay Powell	February 5, 2018 – Incumbent

¹ Served as Chairman Pro Tempore from February 3, 1948, to April 15, 1948.

² Served as Chairman Pro Tempore from March 3, 1996, to June 20, 1996.