Has the Fed Lost Control Over Money?

In my previous article, “How Bernanke Snookered Us All,” I made the case that during a one-month period, mid-August to mid-September, 2007, the Federal Reserve System deflated the adjusted monetary base. As with Austrian economists generally, I define “inflation” as “an increase of the money supply.” I define “deflation” as “a decrease in the money supply.” The adjusted monetary base is the only monetary aggregate that the FED controls directly. I referred readers to the chart and table provided by the Federal Reserve Bank of St. Louis which tracks this statistic. I do so again.

I said that this decrease in the monetary base was significant because this was during a period in which the Federal Open Market Committee (FOMC) of the Federal Reserve System was actively intervening in the market known as the federal funds rate, i.e., overnight loans from banks to other banks. This rate had been exceeding the target rate of 5.25% for over two months. The FED normally intervened once a day to bring this rate back to about 5.25%. I offered a link to a page where anyone may see the daily rate in the FedFunds market: high, actual, and the FOMC’s target rate. Here it is.

So far, we know two facts: (1) during the month leading up to the September 18 announcement by the FED of a reduction in the target rate for overnight bank loans to 4.75%, the FOMC was reducing the one monetary aggregate that it controls directly; (2) the FOMC was actively intervening daily to reduce the FedFunds rate to 5.25%.

Are you with me so far?

My conclusion: the FED was buying repos from the banking system (inflationary — more money in circulation) while selling other assets (deflationary — less money in circulation). The FOMC sold more assets than it bought during this one-month period, which is the only way the adjusted monetary base could fall.

Are you with me so far?

I could be wrong about the FED’s buy-and-sell techniques of this process. I am always open to suggestions. If someone can show me from the statistics how the adjusted monetary base could fall during a period in which the FOMC was actively intervening to push the interday FedFunds rate back to 5.25%, I want to hear it. I will certainly consider it. But I do not see how I can be wrong about the overall effect of this process: more FOMC sales of assets than purchases.

The adjusted monetary base fell. If the FOMC increased its purchases of assets in this period, this indicates that the FOMC has lost control over the monetary base. The base went down, contrary to the action that traditional central bank theory says must raise it: net purchases of assets. If the base fell while net monetary base assets (Federal Reserve credit) increased, this surely calls for an explanation. I am open to suggestions.

There is a second question: “Can the FOMC continue to do this, i.e., lower the adjusted monetary base while also keeping the Fedfunds rate to 4.75?” My guess is that it cannot — not for long, anyway. But that is a guess. The FOMC did it for a month.

I made this comment with respect to long-term FOMC policy:

The table at the bottom of the chart provides the important numbers: the rate of increase from various dates until now. From mid-September, 2006, to mid-September, 2007, the increase was 1.8% per annum. This is what it has been ever since Bernanke took over on February 1, 2006.

An increase of 1.8% is tight money policy by previous FED standards. I have been hammering on this point for a year. The FED has dramatically reduced the rate of monetary inflation.

So, I made it as clear as I could that the FED is not targeting deflation. It is targeting an inflation of the monetary base at about 1.8% per annum. To achieve this, it had to deflate after mid-August. Why? Because it had increased the short-term rate of inflation prior to mid-August. I quoted my August 28 article: While the FED is now pumping in new reserves at a little under 6% per annum, and I expect it to continue this policy for the foreseeable future, I don’t think this will be enough to reverse the sagging economy in the next six months. But if I am wrong, then we can expect a return of accelerating price inflation.

I do not see how I could have been more clear. I did not say that the FOMC is deflating long-term. It is disinflating, compared to what the FOMC had done under Greenspan.


One criticism I received from more than one source was this: the banking system can create credit, which is money, independent of the Federal Reserve System’s monetary base.

At this point, the critics are breaking with what money and banking textbook authors have written about central banking for a century. Let me briefly review the argument of all economists — Austrian, Keynesian, Chicago School, and supply-side.

The central bank creates money when it purchases assets — any assets — for its account. It spends this new money into circulation when it buys an asset. This new money is deposited automatically in the asset-seller’s account in a commercial bank. The fractional reserve process then takes over. This new money is used by the bank to make loans. The banks of the borrowers do the same, setting aside the required non-interest-bearing reserves with the FED. When the process ceases, the reserves deposited with the FED equal the initial purchase of assets by the FED. This is the standard textbook account.

Let us get this clear: the basis of all new credit created by the commercial banking system is the new money issued by the central bank.

In textbooks on money and banking, this process is described by the use of a conceptual tool called a T-account. Step by step, the author shows how the initial deposit of a check in a bank leads to the creation of new credit. The FED makes this initial deposit.

The best textbook I have seen on this process was written by Murray Rothbard: The Mystery of Banking (1983). You can download it for free here.

There are newsletter writers who argue that the banking system as a whole can create credit independently of an addition of Federal Reserve fiat money, which is often called high-powered money. I am surely willing to consider such an argument. What I need is evidence. I need to be shown how the commercial banking system as a whole can issue credit in a form that is not regulated by the central bank’s legal reserve ratio.

As evidence, I would like a reference to some position paper issued by the FED which explains this. Also acceptable: a reference to a textbook or an academic journal that shows how the traditional textbook discussion of reserve requirements is incorrect.

Anyone who argues that fractional reserve banks can create credit that is not under the law regarding reserve requirements is making a very remarkable argument. For one thing, he is making it difficult to understand why the federal funds loan market even exists. The FedFunds market is universally recognized as a market for a bank that has temporarily exceeded its reserve requirement for the creation of new loans (credit) to meet this requirement by borrowing from another bank. Here is the description provided by the Federal Reserve Bank of New York.

Fed funds are unsecured loans of reserve balances at Federal Reserve Banks between depository institutions. Banks keep reserve balances at the Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. Transactions in the fed funds market enable depository institutions with reserve balances in excess of reserve requirements to lend them, or “sell” as it is called by market participants, to institutions with reserve deficiencies. Fed funds transactions neither increase nor decrease total bank reserves. Instead, they redistribute bank reserves and enable otherwise idle funds to yield a return. Technical details on fed funds are described in Regulation D.

Why would any bank go to the FedFunds market or the FED’s discount window to borrow money if it had not exceeded the FED’s reserve ratio requirement? It must pay interest to borrow this money. Banks do not pay interest for no good reason. The official reason is that some banks temporarily have lent out more money than is legal, given the reserve requirement.

Are bankers irrational? No. Are they in the habit of giving away money to other bankers? No. Then why does any bank borrow overnight money in the FedFunds market? The universal answer is: “To meet its reserve requirements for the day.” If this answer is incorrect, then he who argues that the banking system can issue more credit than is allowed by the FED needs to show why this traditional argument is incorrect.

If the monetary base does not set the limit for bank credit, then he who argues this way needs to show why the entire academic field of money and banking has been wrong for over a century. He has to show that Murray Rothbard ignored something fundamental when he wrote The Mystery of Banking and his earlier book, What Has Government Done to Our Money? Because, if the private commercial banks can create credit — money — independent of the government-licensed monopoly of the national central bank, then government is not the culprit that has destroyed our money; commercial banks are doing this on their own.

You can download Rothbard’s other book, which I regard as the best introduction to monetary theory despite being short, free of charge.

There are lots of things about money and banking that I do not understand. But I always thought I understood this: a central bank controls a nation’s money supply by controlling (1) the reserve ratio and (2) the monetary base. Anyone who argues that commercial banks can and do issue credit independently of these two restraints is arguing that traditional monetary theory is incorrect. Such an argument requires considerable evidence.

Again, I am not saying that such evidence does not exist. I am saying that, so far, I have not seen anyone present it, especially those analysts who say that the commercial banking system, as a system, can do this any time it wants.

The bankers always want to maximize their revenues. They do this by creating credit, which is based on their banks’ deposits. They do this at all times. They do not leave a penny on the books in a deposit that is not lent out at all times. Bank credit is always maximized.

Remember this: bank credit is money. Whatever a bank lends is money. This money buys things, which is why borrowers borrow it. They repay in money. Bankers want to be repaid in money. Credit is issued in the form of entries into borrowers’ accounts. There is no bank credit that is not in the form of a deposit in a bank account. So, if anyone is increasing the supply of credit, this credit is in the form of an entry into a bank account. Bank accounts are regulated by the FED: reserve requirements.

What we need to understand from those analysts who argue that the monetary base does not set monetary policy for the nation is exactly how the commercial banking system in the aggregate can issue credit independently of the FED’s monetary base and its reserve requirements (which rarely change).

Is this too much to ask? So, you had better ask it. If someone tells you that the FED has lost control over the monetary system, and that banks can issue credit independently of the FED, ask him to explain why the standard textbook account is wrong, why T-account analysis is wrong, and how on earth Murray Rothbard got it wrong. The person who shows this may even win the Nobel Prize in economics, which is now over a million dollars. It seems like easy money to me for someone who argues that bank credit is independent of deposits in bank accounts.


In my previous report, I wrote this about M-3.

I don’t think my message has penetrated the thinking of most hard-money contrarians. They keep citing M-3, which was canceled by the FED a year ago, and which was always the most misleading of all monetary statistics. Year after year, the M-3 statistic was four times higher than the CPI. The M-3 statistic was worthless from day one. Anyone who used it to make investments lost most (or all) of his money. I have written a report on this, which provides the evidence: “Monetary Statistics.”

I wrote my report on monetary statistics for my Remnant Review subscribers earlier this year. Because so many well-intentioned people have been taken in by M-3, and because so many people claim that there was something sinister in the decision in 2006 of the Federal Reserve to cease publishing M-3 data, I have posted my full report on my website. Normally, I do not do this with Remnant Review issues. Download it here.

The main purpose of following the monetary statistics is to estimate what effect this will have on two things: (1) the price level; (2) the business cycle. Point #1 raises the question: Which statistics of prices?

The theoretical question of constructing a price index is amazingly complex. The best book on the question of price indexes was written in 1950 by economist Oskar Morgenstern, On the Accuracy of Economic Observations. Morgenstern was one of the few men smart enough to be invited by Ludwig von Mises to attend his private seminars in Austria. There is a good presentation of the implications of this book posted on the Mises Institute’s site.

I use the Median CPI figures — and other figures — to see the trend of past prices. I want to have some sense of how rapidly prices are trending upward. The statistics of the Median CPI go back 40 years. They are posted here (this week, anyway; they constantly change its address, which is very annoying).

I update the link whenever the Cleveland FED updates it. It is always on-line at my free department, “Price Indexes” (U.S.A.), here.

I have subscribers who tell me in no uncertain terms that all consumer price index statistics are fake. My response: as long as they are consistently fake, I can still use them to see the trend of prices. Only when the statisticians change their assumptions do the statistics become useless for assessing past periods that were not updated in terms of the revised assumptions. Even jiggered figures are useful if the statisticians retroactively revise previous figures. I can still see the trend.


I maintain that a nation’s central bank controls the nation’s money supply. It does so with two tools: (1) the legal reserve requirement and (2) the purchase (inflationary) or sale (deflationary) of assets in its possession — the monetary base.

If someone says that a central bank does not control the nation’s money supply in this way, then he owes it to his readers to explain either: (1) other ways that the central bank controls money; or (2) the ways that the commercial banks escape the controls set by the central bank. Either of these assertions requires a textbook. Saying that the central bank has lost control does not prove that it in fact has lost control.

September26, 2007

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 19-volume series, An Economic Commentary on the Bible.

Copyright © 2007