May 01, 2022

During the onset of the pandemic Jay Powell and the Trump administration dusted the Financial Crisis playbook. The Fed expanded its balance sheet. The initial response right on point. It provided the backstop that arrested the potential collapse of banking and credit systems. But the fed did more than that. In response to the COVID policies enacted by the Trump administration, government spending and the budget deficit increased dramatically. The Fed accommodated the Trump policies and financed a sizable portion of the deficit. As a result, its balance sheet continued to expand even after the initial crisis had been averted. In fact, the data shows an increase in the excess reserve ratio during the pandemic, pointing to an increase in the fed financial repression policies. The data shows that things changed during the pandemic the inflation rate rose and overshot its 2% target range and is approaching a double-digit rate, something the US has not experienced in 40 years. We attribute this to a combination of factors. First the balance sheet expansion would all else the same resulting proportional increase in the quantity of money. Second the financial repression policies would induce the banks to increase their idle reserve holdings effectively removing hat money from circulation. The combination of the two would result in the increase in M2. Hence an increase in M2 could be attributable to an increase in the balance sheet without a corresponding increase in the financial repression level.

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