• Tag Archives Federal Reserve

  • How Does the Federal Reserve Create Money?

    Posted on by Azrael Comment

    A few weeks ago, I solicited FEE daily readers for their questions about economics. Pretty quickly I got a question I was pretty certain I’d get eventually. It comes from a man named Warren from Chicago who asks:

    “what are the levers used by the Federal Reserve Bank to increase or decrease the money supply?

    I know it has something to do with interest rates and bank reserves, but how does it actually take place and who receives all the extra money in circulation to cause the inflation?”

    There are several channels that the Federal Reserve can use to create money, but I’m going to focus on the two most relevant ones: open market operations and interest on reserves.

    The first way the Federal Reserve can increase the money supply is by creating more dollars. It’s not as simple as them printing dollar bills then throwing them out of a helicopter, though.

    Instead, when the Federal Reserve wants to create money and put it into the system, it does so through banks. Banks hold several types of assets including treasury bonds. Treasury bonds are IOUs that the government issues in exchange for a loan. You buy a bond with cash today and the government promises to pay you back with interest in the future.

    Banks like to hold treasury bonds because they’re viewed as low risk—it’s unlikely the US government will default on debt (any time soon at least). Treasury bonds also have the advantage that they’re relatively easy to sell to someone else to get cash. Economists call this ease of converting an asset into money liquidity.

    The Federal Reserve offers to buy these bonds from banks. When the Federal Reserve buys bonds, they have an advantage you and I don’t. They are allowed to print new money to buy the bonds. It’s more likely that the money will be digitally created than literally printed, but the form of the money doesn’t make a difference.

    The Federal Reserve acquires government bonds and banks acquire newly created money. The process doesn’t stop there, however. Banks don’t generally like to sit on large piles of money because money doesn’t earn interest (unlike the bonds they just sold to the central bank). So what do banks do with their money?

    One thing they can do is make more loans to businesses. The increased supply of funds available to lend out means that there will be more loans available for the same number of businesses. Everything else held constant, this means the price of borrowing (the interest rate) will fall.

    Banks can also turn around and buy more treasury bonds if they want to replace some of the bonds sold. This higher bond demand means the government will be able to take on more debt to finance its spending.

    Economists call this process of the Federal Reserve using newly created money to buy bonds from private banks an open market purchase.

    So how much has the Federal Reserve utilized this tool as of late? Look at this graph:

    Figure 1: Treasury Securities Balances Held Outright

    Since January 2020, The Federal Reserve has increased its treasury securities from $2.3 trillion to around $5.6 trillion today, an increase of around $3.3 trillion.

    A more recent move by the Federal Reserve has been to purchase other types of assets as well. Before 2008, the Federal Reserve owned $0 in Mortgage-Backed Securities (MBSs). Today is a different story.

    I won’t go into detail about MBSs (you can read more about them here) except to say they’re another type of financial asset banks hold which are a good bit riskier than treasury bonds. Here is a graph showing how Federal Reserve MBS holdings exploded in 2008 (in an attempt to alleviate the housing crisis) and again in 2020 (in an attempt to curb the negative effects of COVID policies).

    Figure 2: Mortgage Backed Securities Held Outright

    As you can see, the Federal Reserve acquired around $1.3 trillion worth of mortgage backed securities from January 2020 to today.

    As economist Jim Gwartney pointed out for AIER,

    “[the] $4.2 trillion increase in federal spending over the two [COVID] years was financed entirely by borrowing from the Fed. Fed holdings of financial assets, mostly Treasury bonds and mortgage-backed securities of federal housing authorities, increased from $4.2 trillion in February 2020 to $8.8 trillion in December 2021.”

    So now we understand how the Federal Reserve creates new money, and who it goes to. Banks are the first recipient, and borrowers or those who sell financial assets banks demand (including the government itself) are the second recipients. And as Warren alluded in his question, this policy indirectly influences the interest rate.

    There’s one other important tool for how the Federal Reserve can influence the creation of money. It’s a relatively new policy lever called interest on reserve balances (IORB).

    To understand how the Federal Reserve impacts the money supply through IORB, you need to have a basic understanding of our banking system.

    Let’s say Warren deposits $1,000 in his bank, FEEbank. What happens to the money then? In the United States, it’s unlikely that the money will sit in a vault. Instead, FEEbank will likely try to make a return on that money by lending some of it out to someone else.

    So let’s say Jim comes and asks for a loan of $800 from FEEbank. FEEbank lends out $800 of Warren’s $1000. So how much money does Warren have? Well, when the bank lends out your money, your balance doesn’t go down. Warren can still go withdraw his money so long as the bank can give him deposits they’ve kept from other customers.

    If everyone came to get their money at once, the bank would run out of money, but so long as that doesn’t happen, FEEbank doesn’t have a problem.

    So now Warren has $1,000 and Jim has $800. There is now $1,800 in the economy compared to $1,000 before. FEEbank created more money!

    The process doesn’t even have to end there. Jim can deposit the $800 in another bank, which can lend out a portion to someone else.

    This system of banking is called fractional reserve banking because banks only keep a fraction of your deposits as reserves, and they loan out the rest.

    So private banks in this system can create money by lending deposits, but what does this have to do with the Federal Reserve?

    In 2008, the Federal Reserve adopted a policy of paying banks interest for the money they kept in reserves. So, instead of FEEbank loaning out Warren’s money, the Federal Reserve could offer to pay FEEbank to keep the money in the vault.

    The higher the interest the Federal Reserve offers to pay FEEBank, the less likely it is to lend out the money. Why make a risky loan at a 3.5% interest rate if the Federal Reserve will pay you 3.5% for keeping it in the vault? The Federal Reserve is essentially paying banks to not make loans.

    Notice, too, this also allows the Federal Reserve to more directly control the interest rate. If the Federal Reserve wants loans to have a 4% interest rate, all the agency has to do is promise to pay 3.9% IORB to not make the loan. In that case, a private borrower would have to offer at least 4% to beat the Federal Reserve.

    So if the Federal Reserve wants banks to lend more of their deposits thereby creating more money, all they need to do is lower the IORB. And that’s exactly what they did during COVID.

    In January 2020, the interest rate on reserves was 1.55%. By mid-March 2020, the Federal Reserve had dropped the rate to 0.1%.

    This policy made it relatively more lucrative for banks to increase lending and, everything else held constant, when the benefits of an action goes up, people will do more of that action.

    The result of these policies has been a large increase in the supply of money. Economists measure what counts as money a few different ways, but one of the most commonly used and accepted measures is called M2.

    From January 2020 to January 2022, the M2 money supply increased from $15.4 trillion to $21.6 trillion.

    That’s a 40% increase in the money supply— unprecedented in recent US history.

    Figure 3: M2 Money Supply

    As I’ve explained since May of last year, this increase in money supply inevitably led to higher prices across the board (aka inflation). FEE’s Dan Sanchez has explained this in depth as well.

    Unfortunately, the Federal Reserve seems to have printed itself into a corner.

    Utilizing open market purchases and lowering IORB may have propped up the economy by stimulating lending and investment in 2020, but the chickens are coming to roost. At this point, if the Federal Reserve wants to use its levers to bring inflation down, it’s going to do so by hurting investment opportunities.

    As of this month, the IORB has been raised to 3.15%. This means less funds will be available to borrowers. Whether we’re in a technical recession or not right now, it seems unlikely to me the Federal Reserve will be able to bring inflation down without allowing an economic correction to take place.

    There’s no such thing as a free lunch. Printing dollars does not mean there are more sandwiches to go around. And although the Federal Reserve can affect the economy with their levers, they cannot print prosperity.


    Peter Jacobsen

    Peter Jacobsen teaches economics and holds the position of Gwartney Professor of Economics. He received his graduate education at George Mason University.

    This article was originally published on FEE.org. Read the original article.


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  • The Federal Reserve is Embracing Left-Wing Policies—Here’s Why You Shouldn’t Be Surprised

    Posted on by Azrael Comment

    The Federal Reserve System has come under fire in the last few months for extending itself into areas outside its Congressional “dual mandate” of stabilizing prices and maximizing employment. There are two areas where the Fed is being accused of overreaching.

    The first area is economic equality. For example, the Federal Reserve Bank of New York website greets visitors with a message stating, “we are firm in the belief that economic equality is a critical component for social justice.” Senator Pat Toomey recently sent letters to several Regional Federal Reserve Banks criticizing this policy pursuit of economic equality as, “wholly unrelated to the Federal Reserve’s statutory mandate.”

    The second area, environmental policy, has also become a more central focus. Economist Alex Salter reports that the Fed recently created two climate committees and joined a group dedicated to making the financial system more environmentally focused. And, although Chairman Jerome Powell says the Fed isn’t trying to set climate policy, a report out of Reuters alleges that the Fed has begun to pressure banks to assess climate risk.

    As a result of this public shift, Salter has published an open letter with 42 distinguished co-signatories expressing concern. The letter’s author and co-signers are bothered by the Fed’s mission creep, and call for the Fed to focus on monetary policy and money, rather than activism.

    While this concern is well-placed, it’s important to note that the Fed abandoning political independence is nothing new. The Fed has a long history of breaching its political independence “norms.”

    Perhaps the most famous example of this was when then-President Richard Nixon pressured Fed Chairman Arthur Burns into crafting monetary policy in a way that would help his re-election. A recorded conversation between the two has Nixon laughing about the idea of political independence:

    “‘I know there’s the myth of the autonomous Fed . . .” Nixon barked a quick laugh. “…and when you go up for confirmation some Senator may ask you about your friendship with the President. Appearances are going to be important, so you can call Ehrlichman to get messages to me, and he’ll call you.’”

    However, the Fed hasn’t only been beholden to politicians—special interest groups also appear to have power over the Fed. After the 2008 financial crisis, a new wave of bank regulators was sent to deal with large financial institutions such as JPMorgan and Goldman Sachs. One regulator sent by the New York Fed, Carmen Segarra, released recorded conversations between herself, her supervisors at the New York Fed, and officials at Goldman Sachs.

    In the conversations, Segarra is urged by her supervisors at the Fed to change her report suggesting Goldman Sachs had an insufficient policy for dealing with conflicts of interest. When she refused, Segarra was fired by the Fed.

    Although being urged to change her report may be the most egregious example, the common theme in the tapes is clear: the Fed regulators seem more like partners of Goldman Sachs than watchdogs.

    The takeaway is clear. The Fed has a storied history of political corruption, and this shouldn’t be surprising.

    To understand why we should expect corruption from the Fed we need to consider the lessons of Public Choice economics.

    Public Choice looks at politics as an exchange. Bureaucrats, politicians, and political appointees, for example, want things like good jobs after retirement, funding for political projects, and valuable relationships with powerful people. In order to obtain these things, these political actors may be willing to craft policies to benefit special interest groups or other politicians.

    Consider, for example, the Fed. One of the powers the Fed has is the ability to print new money. When a new 100 dollar bill is printed, the first person to receive the new money will be able to use it to buy real goods and services. If they buy a TV, for example, the new 100 dollar bill goes to the person who sold the TV. However, as the new dollar bill is spent more and more, the increased demand it creates leads to higher prices, everything else held constant.

    So while the first people to get the new money get a good deal, it leads to higher prices for everyone else. Inflation is like a hidden tax on whoever gets new money after the prices have risen. Receiving new money first, then, is a privilege that some may be willing to pay for. If it only costs you $90 to lobby the Fed for a new 100 dollar bill, you come out $10 richer.

    Printing money isn’t only beneficial for those who receive the money first, though. As the example of president Nixon highlighted, politicians focused on short-term re-election goals may be interested in giving favors, privileges, or punishments to members of the Fed in order to improve the economy before an election.

    Finally, the Fed’s regulatory role in banks is another “asset” special interests would like to purchase. The Segarra tapes show a clear example of how powerful special interest groups can use their influence to control the regulations within their industry. Economists call this “regulatory capture.”

    So, although I ultimately agree with Salter’s open letter, it’s important to recognize that what’s happening isn’t very new. The Fed has long been involved in pursuing goals other than monetary stability. The only new development is the mask is dropping. The Fed is now being more transparent about its other activities.

    And while I’d like to believe we can reign in the Fed and convince its members to follow rules, I’m not so sure. The Fed, as an institution, has the ability to transfer enormous amounts of wealth from some groups to others in the form of inflation and regulation. Given the enormity of these transfers, it seems unlikely that self-interested politicians will be willing to give up that power any time soon.


    Peter Jacobsen

    Peter Jacobsen is an Assistant Professor of Economics at Ottawa University and the Gwartney Professor of Economic Education and Research at the Gwartney Institute. He received his PhD in economics from George Mason University, and obtained his BS from Southeast Missouri State University. His research interest is at the intersection of political economy, development economics, and population economics.

    This article was originally published on FEE.org. Read the original article.


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  • Coronavirus Crisis Exposes a Devastating Consequence of Fed Policy: Americans Have No Savings

    Posted on by Azrael Comment

    During a March 17 address to the nation in response to the COVID-19 outbreak, President Donald Trump asked that Americans work from home, postpone unnecessary travel, and limit social gatherings to no more than 10 people.

    Ten days later, Trump signed a stimulus package of more than $2 trillion to provide relief to an economy on the precipice of collapse.

    The aid package includes handouts and loans to individuals, small businesses, and other distressed industries.

    Despite Trump “having created the greatest Economy in the history of our Country,” when the markets tanked, massive and immediate government intervention was the only thing left to forestall a total collapse.

    So why can’t the greatest economy in the world handle a temporary shock without needing trillions of dollars injected to stay afloat?

    The Federal Reserve and its vicious and ongoing war on savers are to blame.

    Using the Federal Reserve Note—commonly (but incorrectly) referred to as the dollar—introduces a dilemma. Because of inflationary monetary policy, Americans have long been forced to select among three undesirable options:

    A) Save. Hold Federal Reserve Notes and be guaranteed to lose at least 2 percent in purchasing power every single year.

    B) Consume. Spend Federal Reserve Notes on immediate goods and services to get the most out of current purchasing power.

    C) Speculate. Try to beat the Fed’s deliberate inflation, seeking a higher return by investing in complicated and unstable asset markets.

    With businesses and Americans defaulting on their rent and other obligations only days into the collapse, the problem is clear: Few have any savings. And why should they when saving their money at negative real rates of return has been a sucker’s game?

    Lack of sound money, or money that doesn’t maintain its purchasing power over time, has discouraged savings while encouraging debt-financed consumption.

    American businesses and individuals are so overleveraged that once their income goes away, even briefly, they are too often left with nothing.

    Fiat money is especially pernicious in the way it harms its users. To some, two percent losses can go easily unnoticed, year to year. Over 100 years, the loss has been well over 97 percent.

    And who can save for emergencies when you’re being forced to work and spend more—simply to maintain the same quality of life?

    Over 100 years, the Federal Reserve has destroyed more than 97 percent of our currency’s purchasing power.

    With the Fed slashing short-term rates to zero, the US Federal Reserve Note has been further destroyed as a method of preserving savings. (And negative nominal interest rates could be coming next.)

    Inflationary economic policy, absent the guardrails of sound money, has created a situation with an obvious and deadly conclusion: that many Americans lack savings to protect themselves against downturns.

    This situation isn’t necessarily the fault of the people, but rather the fault of a system in which discouraging and punishing savers is a crucial tenet of the entire framework.

    The Federal Reserve, the US Treasury, and the White House are trying to reassure the public that everything is “under control,” that “the US economy’s fundamentals are still strong,” and that the economy will skyrocket once COVID-19 is taken care of. What if they’re wrong?

    Maybe the greatest monetary experiment in history is coming to an end. Maybe sound money can still save the day, but we must not waste any more time in restoring it.


    Jp Cortez

    Jp Cortez is Policy Director for the Sound Money Defense League, a non-partisan, national public policy organization working to restore sound money at the state and federal level and which maintains America’s Sound Money Index.

    This article was originally published on FEE.org. Read the original article.


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