Some commentators have suggested the Paulson / Bernanke financial rescue plan represents a “monetisation” of illiquid mortgage-backed securities, implying longer-term inflationary consequences. On current information, such concerns appear unwarranted.

“Monetisation” would involve one or both of the following:

• An increase in the monetary base, i.e. currency in circulation and banks’ reserves held at the Fed.

• An increase in the broad money supply, i.e. cash, deposits and other liquid assets held by the non-bank private sector.

The Fed has hugely expanded its lending to the banking system against lower-quality collateral over the last 12 months but has sterilised the impact on the monetary base by selling Treasury securities. There is no current reason to think this approach will change. The further measures announced in recent days – including the loan to AIG, a new facility allowing banks to borrow to buy asset-backed commercial paper and planned Fed purchases of agency securities – will be financed mainly by the Treasury issuing additional bills and depositing the proceeds with the Fed, implying no impact on bank reserves.

Under current arrangements whereby the Fed does not pay interest on bank reserves, failure to sterilise the impact of its lending on the monetary base would push the effective fed funds rate down to zero. To keep the rate near the policy target of 2% while expanding the monetary base, the Fed would have to start paying interest on reserves at close to this level. There has yet to be any discussion of this possibility.

With respect to the broad money supply, the key point is that the Paulson / Bernanke plan involves the government buying suspect assets from banks rather than non-banks so there is no direct impact on the money holdings of the latter. If the scheme is financed by selling additional Treasury bills to banks, the net effect will be to increase the proportion of high-quality liquid securities on their balance sheets while leaving total assets unchanged. To the extent that funds are raised by selling additional Treasury securities to the non-bank private sector, there will actually be a negative first-round impact on the broad money supply and aggregate bank assets.

Of course, a successful scheme resulting in a normalisation of money and credit markets would increase banks’ willingness to lend, implying an indirect boost to monetary expansion.

Should the US authorities consider measures to boost broad money growth as part of their efforts to restore financial stability and stave off economic weakness? My favoured broad liquidity measure – M2 plus institutional money funds, commercial bank large time deposits and commercial paper outstanding – is still rising at a 9% annual rate, suggesting concern over monetary deficiency is premature. However, the shorter-term trend is weaker and bears close monitoring – see chart.