Over the past 35 years, the Federal Reserve has attempted to manipulate the economy through monetary policy. The basic theory behind this policy--monetarism--was a belief that the growth in the quantity of money would affect economic activity. The theory stipulated that the Fed would maintain a specified growth target for various measures of the money supply and then manage policy, i.e., manipulate interest rates, to control the growth of money. The problem with this money-growth relationship is that, as a point of logic, it can be shown that with today's policy of a floating exchange rate for the U.S. dollar, causation runs from the economy to the aggregates, and not vice versa.
When the banking system makes loans, it simultaneously creates deposits, and the Fed subsequently requires that banks keep reserves in their member bank reserve accounts at the Fed against certain classes of deposits. Banks make loans first and worry about reserves later. Though banks can exchange reserves in the fed funds market to attempt to meet reserve requirements, only the Fed can increase or decrease total system-wide reserves. Therefore, in the case of a system-wide shortage of required reserves, at least one bank will ultimately be forced to borrow directly from the Fed, generally as a last resort, through the discount window (functionally this is an overdraft facility). Reserves supplied by what are called 'operating factors,' including open market operations, become 'non borrowed' reserves for the banking system, while reserves borrowed via the discount window are accounted for as 'borrowed reserves.' Operationally, the Fed always keeps the banking system in a "net borrowed" condition by making sure its open market operations fall short of the total demand for reserves, forcing some banks to borrow from the Fed's discount window. This keeps the fed funds rate above the discount rate, as banks would prefer to borrow fed funds rather than utilize their privileges at the Fed's discount window. The spread between fed funds and the discount rate is determined by the size of the net borrowed position the Fed supports via open market operations. The higher the net borrowed position the wider the spread, as at the margin more and more banks are forced to the discount window and the stigma such borrowing carries. So, for example, if the Fed deems it appropriate to 'tighten,' it can raise the fed funds rate by either increasing the discount rate and leaving the net borrowed position constant, or by increasing the net borrowed position and raising the spread between fed funds and the discount rate.
When banks are unwilling to lend or loan demand is sluggish, deposits and bank reserves will not grow. Again, the causation runs from bank lending to the creation of reserves and not from the idea that the Fed pumps reserves into the banking system that produce bank lending. For example, if the Fed attempted to add excess reserves to the system to increase bank lending, the resulting system-wide excess bank reserves would quickly drive down the fed funds rate as banks sold unneeded reserves to each other. Since excess reserves don't earn interest at the Fed, the fed funds rate would fall to zero bid (as in Japan today) if excess reserves were allowed to persist. The effect on lending would only be that of the zero interest rate, since as previously discussed, bank lending is never 'reserve constrained.'
The monetary base consists of two components: reserves of member banks held at the Fed (to support deposits) and currency in circulation. There is an important difference in the growth rates of these components. Since October 2001, there has been no sustainable growth in bank reserves (Exhibit #1). The temporary increases in reserves were related to the Y2K liquidity scare and the impact of the terrorist attacks in New York and Washington, D.C. These two surges in reserves identify the key role the Fed plays in the economy: lender of last resort. In times of crisis, the Fed has the power to provide the reserves needed to avoid financial panic. Other than these times, reserve growth is determined by bank lending.
The power behind the growth in the monetary base has been the underlying growth in currency (Exhibit #2). Note the difference between a surging currency in late 2000 as banks' demand for currency for potential Y2K withdrawals ballooned currency growth while there was no surge in currency in September of 2001 in the aftermath of the terrorist attacks. Since October 2001, the growth rate in currency has been about 8.8%--sufficient growth to meet the needs of money as a medium of exchange and probably sufficient to meet the needs of countries where the dollar circulates freely as if it were the country's currency.
Don't be fooled into thinking that the growth of the monetary base implies that the Fed is pumping in liquidity- as there is no such thing- or that lending is expanding, as the growth in the monetary base has been in cash in circulation.
The Fed controls the price of credit money -- the fed funds rate--but it cannot control the quantity of bank deposits (and 'credit money' in general), as it is the effective demand for credit that determines the quantity of loans and therefore deposits. The current fed funds rate reflects the interaction of supply and demand for bank reserves among banks, as determined by the Fed through the supply of total reserves and the mix between borrowed and non-borrowed reserves. Note that, since January 1998, while the Fed manipulated the fed funds rate dramatically, changes in bank reserves have been minimal (Exhibit #3).
Given these relationships, actions to ease money through a lower Fed funds rate will have a minimal effect on reserves unless there is a major increase in credit-worthy loan demand at lower rates.
Conclusion:
The Fed controls the price of credit money -- the fed funds rate--but it cannot control the quantity of bank deposits (and 'credit money' in general), as it is the effective demand for credit that determines the quantity of loans and therefore deposits. The current fed funds rate reflects the interaction of supply and demand for bank reserves among banks, as determined by the Fed through the supply of total reserves and the mix between borrowed and non-borrowed reserves. Note that, since January 1998, while the Fed manipulated the fed funds rate dramatically, changes in bank reserves have been minimal (see below). Given these relationships, actions to ease money through a lower Fed funds rate will have a minimal effect on reserves unless there is a major increase in credit-worthy loan demand at lower rates.
The only option available to the government to increase economic activity and improve consumer confidence in the near-term is additional fiscal stimulus through major tax rate reductions. The elimination of the corporate income tax, substantial reductions in individual tax rates, and a temporary suspension of the payroll tax are examples of the elixirs necessary to get the economy back on a sound growth track.