Fed Governor Duke Admits Text Book Monetary Linkages not Operative

Econintersect: Federal Reserve Governor Elizabeth A. Duke offered a little candid opinion of the obvious in a speech to the Maryland Bankers Association First Friday Economic Outlook Forum in Baltimore. 

……..the linkage between the level of reserve balances and the monetary aggregates in the current environment is quite weak. You were probably taught, as I was, that the broad monetary aggregates increase when reserve balances increase because the larger volume of reserves supports increased lending, which in turn leads to a larger volume of reservable deposits. While that argument might hold in normal circumstances, in the current environment excess reserves are many multiples of required reserves, and adding reserves is unlikely to spark a further increase in the volume of deposits. As a result, the textbook linkage between reserve balances, bank loans, and transaction deposits just is not operative at present. Fundamentally, the levels of M1 and M2 are determined by the strength of the economy and the preferences of businesses and consumers for money, which depend on the yields on monetary instruments and competing assets.

Recent experience has again illustrated the difficulty in identifying a reliable relationship between reserve balances and the monetary aggregates. Even though Federal Reserve actions to fight the financial crisis and support the economic recovery added roughly $1 trillion to a base of about $43 billion in aggregate bank reserves, M1 and M2 rose at relatively moderate rates over the same period.

Duke gave a standard Fed overview of the current economic conditions:

Overall, the recovery in economic activity to date has been uneven and has not been sufficient to reduce unemployment noticeably. But I am encouraged by signs that the recovery may have gained traction recently. And I believe that sustained gains in consumer spending and business investment and a further easing of credit conditions will reinforce each other, leading to greater confidence and improving the prospects for an extended expansion that, over time, will reduce unemployment to a level consistent with full employment. At the same time, I anticipate that inflation will remain subdued. Finally, I believe that the actions taken by the FOMC to support the economic recovery are appropriate, and I am confident in our commitment to monitor economic conditions and take action as needed.

To read the entire speech – click here.