A common refrain among the “cut, cut, cut” chicken littles and the hard-money crowd is that “the Fed has turned the printing presses lose printing money”. These folks should really join us in the 21st century. That’s not how it works and that’s not what The Fed has been doing. Quantitative Easing, as well as The Fed bailouts of the big banks 2-3 years ago, did not involve “printing money”. It involved creating bank reserves that are NOT loaned out and therefore do not create new “money” or M1. James Hamilton explains:
I wanted to offer some clarification on stories about all the money that the Federal Reserve is supposedly printing. It depends, I guess, on your definition of “money.” And your definition of “printing.”
When people talk about “printing money,” your first thought might be that they’re referring to green pieces of paper with pictures of dead presidents on them. The graph below plots the growth rate for currency in circulation over the last decade. I’ve calculated the growth rate over 2-year rather than 1-year intervals to smooth a little the impact of the abrupt downturn in money growth in 2008. Another reason to use 2-year rates is that when we’re thinking about money growth rates as a potential inflation indicator, both economic theory and the empirical evidence suggest that it’s better to average growth rates over longer intervals.
Currency in circulation has increased by 5.2% per year over the last two years, a bit below the average for the last decade. If you took a very simple-minded monetarist view of inflation (inflation = money growth minus real output growth), and expected (as many observers do) better than 3% real GDP growth for the next two years, you’d conclude that recent money growth rates are consistent with extremely low rates of inflation.
Two year growth rate (quoted at annual percentage rate) of currency in circulation. Data source: FRED.
But if the Fed didn’t print any money as part of QE2 and earlier asset purchases, how did it pay for the stuff it bought? The answer is that the Fed simply credited the accounts that banks that are members of the Federal Reserve System hold with the Fed. These electronic credits, or reserve balances, are what has exploded since 2008. The blue area in the graph below is the total currency in circulation, whose growth we have just seen has been pretty modest. The maroon area represents reserves.