Back in the heyday of Chicago-Friedman-style monetarism, there was some semblance of a stable, though not constant, relationship between the monetary base and nominal GDP. It sure looks as if that stable relationship has been changed or destroyed.
Back in 2009, when I saw that the monetary base had been expanded dramatically in late 2008, I was very concerned that all that extra liquidity would create massive inflationary pressure. Quite clearly my concern was misplaced (i.e. wrong). Here is a chart, courtesy of Bloomberg, that shows what concerned me back then:
As you can see, the ratio of the monetary base in the US to US GDP was pretty stable between 2000 and mid-2008. That sudden jump in the monetary base in late 2008 scared the bejesus out of me. What was the Fed thinking? Didn't they know that would be a massive inflationary move? Here is another graph of the monetary base, not as a ratio, showing the dramatic changes in 2008 [from Wikipaedia]:
Here is a possible explanation for why I was wrong.
Look at the flat (even slighly declining) ratio of the monetary base/GDP leading up to the 2007 financial crisis. If the monetary base/GDP ratio wasn't growing, where was all the liquidity coming from to fuel the housing boom/bubble in the US? Clearly the liquidity was being created somewhere, and it wasn't just an influx of funds from Europe (which one might think, given that upper graph). Certainly some (a bunch?) of it was an influx of saving from Asia, as Fed analysts and others had been writing since the early 2000s. But a whole lot more of it was being created by the shadow banks who were leveraging themselves up quite quickly. What that says, though, is that the previous understanding of the link between the monetary base and economic activity was already changing or even falling apart. The Fed had controlled the monetary base and yet there was an immense asset bubble, fueled by liquidity over which the Fed had little control.
Another factor that affected the linkage between the monetary base and nominal GDP was the Fed's decision in late 2008 to pay interest on commercial bank reserves held at the Fed. As I suggested back then, banks have chosen to hold massive amounts of excess reserves rather than extend as many new loans as one might otherwise expect. So the creation of a much larger monetary base did little more than offset the effect of paying interest on reserves to some extent: paying interest on reserves cut down on liquidity while increasing the monetary base would increase liquidity.
Given that the Fed is still paying interest on bank reserves, it has to keep pumping up the monetary base. In the process, of course, it is creating massive amounts of excess reserves (about which I fretted unduly [?] back in 2009). As economic activity picks up, banks will find many profitable opportunities for using these excess reserves by making loans and creating more liquidity. If that process happens quickly, the US could find itself with more inflation than it expects or than the Fed can offset quickly. And it is more than a vague concern about this possibility that I detected in Charles Plosser's voice when I talked with him at the Rocky Mountain Economic Summit and that underlies the headling on the Bloomberg graph included above.
Should inflation become much higher and much more severe than the Fed expects, it can always decide to pay a lower interest rate on commercial bank reserves. But that is a pretty broad, blunt tool. And perhaps this nagging concern explains why many members of the Fed are urging that "tapering" begin sooner rather than later.