Money supply can either be increased by Central banks directly “printing” the so-called high-powered money (issued bills and coins, plus commercial bank reserves with the central bank) or having by commercial banks creating scriptural money through lending.
As Central Banks flooded banks with liquidity in the aftermath of the 2008 financial crisis, the share of high-powered money increased rapidly. However, it continues to represent a minority of the total money outstanding:
Focus on the Money Supply circulating into the economy
If liquidity injections are not inflationary insofar as they stay on banks’ balance sheets, we should be deducting banks’ reserves from Money Supply aggregates when studying them. For instance, between 2008 and 2012, M2 increased by close to 30% due to the first round of QE, from $7.5tn to $9.7tn. In the meantime, inflation only rose 7.8% (about 1.8% annualized), increasing far slower than Money Supply, enough for some to believe that the link between money and inflation had broken down. However, most of the increase in Money Supply was then hoarded as reserves by banks’ eager to rebuild their liquidity. Consequently, the amount of money circulating into the economy only has only risen 8.5% during this period, very much in line with inflation.
M2 in Circulation Accelerates as Banks’ Step Up Lending
Central Banks’ attempt to constrain Money Supply by increasing the cost of credit is failing to meet its objective. As interest rates rise, commercial banks are incentivized to lend at a time where individual and companies’ creditworthiness was artificially boosted by successive rounds of stimulus cheques. As a result, the pace of lending picked up significantly which incidentally accelerated the amount of money circulating in the economy even as traditional monetary aggregates stalled.
While raising interests will indeed limit the demand for credit in the long term, it fails to do so in the short term. Therefore, the only alternative to contain money supply and tame inflation over the medium to long term is to drain the excess liquidity out of the banking system via an aggressive round of Quantitative Tightening. In that regard, the monthly sales of $60bn worth of Treasuries looks like a drop in the bucket.
