The Central Bank of America is the Federal Reserve, responsible for deciding how much money is in the economy. To most people, that means that the Fed “prints” money, but that is not actually the case; only the Treasury “actually” prints money. The Fed’s actions have an incredible effect on the economic stimulus it is trying to create.
In our continuing series on the Federal Reserve Bank, I thought it would be appropriate to discuss the Fed’s effect on the economy at this time. With the recent economic stimulus package signed by Congress, it might be a good time to discuss how the Fed fits in with all of the talks of economic stimulus.
As I write this article on March 26, 2020, we are in the midst of the Coronavirus pandemic that has taken the world by storm. The virus has disrupted life as we know it and has cost thousands of people their lives.
It has also thrown the world’s economies into shambles, with multiple countries either planning on some economic stimulus package or already passing one.
My attempt to unravel how the Fed works in all of this is meant as an educational idea, not any political ideology. The information I will share with you is purely from how the system works, not whether it is right or wrong. That is for others who are far better educated than me to decide.
Items we will discuss in the article:
- The Dual Mandate
- Expansionary Monetary Policy
- Contractionary Monetary Policy
- How does the “creation” of money affect the economy?
Ok, let’s take a look at how all of this works.
The Dual Mandate
Job number one for the Federal Reserve is keeping the economy healthy and strong. We have tasked the Fed with a dual mandate of price stability and maximum employment.
The Fed does this by controlling the nation’s system of money and credit or monetary policy.
The first component of the dual mandate is price stability, which means that the country is not experiencing increasing inflation or variable deflation.
Studies have shown that the economy is strongest when interest rates are on a lower scale, which corresponds with low inflation.
Low-interest rates allow businesses to borrow money to grow and increase payroll to match this growth. In this environment, employment is low, and the economy is allowed to grow.
When prices are stable, consumers can confidently buy everything from bananas to a new car.
We can measure the Fed’s success by the long-term ability to maintain stable prices. To do this, the Fed sets several targets:
- Amount of money circulating in the economy
- Level of reserves held by banks (commercial and Reserve Banks)
- Level of interest rates ( high or low)
The Fed sets its goal for inflation at 2 percent. When the Fed sets policy, it looks to the long run, not the short term. Some of its policies may affect the short term, but its goal is the long term.
They must look to the future and attempt to head off inflation or deflation in the past before either becomes a problem.
Most of us are familiar with inflation, but what do you know about deflation?
Let’s talk about that for a moment.
Deflation occurs when prices fall throughout the economy, causing the inflation rate to be negative. A deflationary period occurs when the inflation rate falls below zero.
Think of deflation as a period when your dollar goes further as the prices of goods and services fall. It is also a time of monetary contraction, meaning that the supply of money and credit is dwindling.
The importance of the Fed’s action can be illustrated by thinking about it this way: If inflation is at the target of 2% for two years, then it is easy to plan and spend your money. But if after two years it rises to 5% and then 9% the next year, our money is not going as far, and it is far harder to plan for any additional purchases.
That applies to both consumer and business decisions.
The second mandate has the economy at maximum employment. Maximum employment can be defined as eliminating the kind of cyclical employment that rises when the economy is in a downturn. Today, 3.3 million people filed for unemployment, the largest in our country’s history.
The Fed has been tasked with maintaining maximum employment and can use any of its monetary tools as the economy worsens.
The bottom line is that the Fed has a difficult job of juggling pricing stability and maximum employment. If the Fed focuses on one aspect, the other could falter, and vice versa. As we discussed last week, the FOMC has to be mindful of the road ahead at all times.
Expansionary Monetary Policy
With the threat of recession, we are entering a phase of expansionary monetary policy in today’s economy.
Expansionary monetary policy is when the Fed uses all its tools to jump-start the economy. It is usually done during a recession, like the Great Recession of 2007 to 2009.
The expansionary monetary policy increases money in the economy, lowers interest rates, and increases demand. Not all of these happen at once; they are usually cumulative effects.
One aspect of this policy is not discussed much: it decreases the currency’s value. We will return to this point in time.
Open market operations are the Fed’s most used tool for creating expansionary policy. They involve buying Treasury notes from its other member banks, which creates credit.
Where does it get the money to do this?
More on that in a moment.
By replacing the Fed’s Treasury notes with credit, the Fed gives itself more money to lend to businesses or consumers. The Fed offers lower interest rates to make the credit more appealing to consumers. This makes loans for cars, businesses, and mortgages less expensive. Credit card rates are also lowered with this process. This cheap credit boosts spending, or that is the theory and puts more “money” back into the system.
Another tool the FOMC may use is the Fed funds rate. If you remember, this is the rate banks charge each other for overnight deposits. By law, the Fed mandates that each consumer bank must keep a certain amount of deposits in reserve at their regional Reserve bank each night.
Consumer banks with more than they need in reserve will lend that money to each other and to those that don’t have enough, and the interest will be charged at the Fed funds rate.
When the Fed funds rate drops, banks have cheaper money to hold in their reserves, which allows them to lend out at a cheaper rate.
The third tool at the Fed’s disposal is the discount rate. The discount rate is the rate that the Fed charges banks when they borrow from its discount window. Using this rate is a last resort for banks because it has a stigma attached.
The Fed is considered a lender of last resort, and banks will only use the discount window when they cannot borrow from other consumer banks.
Interest on reserves is a new fourth tool created during the Great Recession. Congress granted the Fed this new tool after 2007-2009.
Interest on reserves is money paid on excess reserves held in Reserve Banks. The Fed requires all consumer banks to hold a percentage of their deposits at the Reserve Banks. Most banks hold extra reserves in the Reserve, which gives them the potential for more interest to be earned.
The extra boost is designed to give consumer banks more money to lend at a cheaper rate, thereby putting more money into the economy.
If the Fed wants to encourage more lending, it can do this by lowering the interest rate on consumer banks’ reserves. Banks are more likely to lend that money than hold on to it, as they make money on the spread between interest rates.
Contractionary Monetary Policy
On the flip side of expansionary, we have a contractionary monetary policy. The Fed uses contractionary monetary policy to fight inflation, which occurs when the economy is a runaway train.
The bottom line is that the Fed will raise interest rates, which will help slow the economy and create less liquidity. Raising the rates will make lending more expensive, reducing the money and credit banks are willing to lend. This leads to a lower money supply by making loans, mortgages, credit cards, and car loans more expensive.
The main goal of contractionary monetary policy is to combat inflation. A little inflation is normal and healthy; a 2% price increase is good for the economy because it creates demand.
When people see prices rise, they naturally buy more because they are afraid that prices will go up to the point that they can’t afford items, and this causes inflation to skyrocket.
The Fed attempts to slow that demand by making purchases more expensive. It raises bank lending rates, which makes all borrowing more expensive, such as mortgages, car loans, and credit cards. All of this dampens spending and causes inflation to return closer to the target of 2%.
The Fed tracks inflation by using the core inflation rate. Core inflation is year-over-year price increases, less the more volatile food and oil prices. To measure this, the Fed uses the Personal Consumption Expenditures Price Index. If the Fed sees the PCE Index core inflation rise about the 2% target, it then starts with contractionary monetary policy.
The Fed began selling Treasury Notes to consumer banks to initiate contractionary policy. The bank must pay the Fed for these Treasury Notes, which leads to having less money to lend. This action causes the banks to raise interest rates because they have less money to lend, and to make the same amount of interest income, they need a bigger spread on the interest they charge on any lending.
The Fed can also utilize its second tool, raising the Fed funds rate, which raises interest rates. As you might recall, this rate is the rate that each bank is charged to hold a reserve overnight to meet its deposit requirements. The Fed will raise the Fed funds rate to decrease the money supply.
The third tool, the discount rate, is rarely used by other banks. The discount rate is what the Fed charges other consumer banks to borrow from its discount window. Banks rarely utilize the discount window, even though the rates are lower than the fed funds rate. The reason for this is that other banks will see them as weak if it is forced to borrow from the discount window. That means that banks are less likely to lend to other banks that borrow from the discount window.
An example of how some of these forces can play out would be the Great Depression. According to Ben Bernanke, former Fed Chairman, contractionary monetary policy caused the Great Depression. The Fed had instituted a contractionary policy to stop the hyperinflation of the last 1920s. Bernanke stated that during the stock market crash 1929, it didn’t switch over to expansionary policy, which they should have done. Instead, the Fed stayed the course with contractionary policy and raised rates.
The Fed continued that policy because, at the time, the dollar was backed by the gold standard. The Fed didn’t want people selling their dollars for gold, thus depleting the gold reserve at Fort Knox. Instead, their decision to continue contractionary policy preserved the dollar’s value and touched off massive deflation. All of this helped turn the recession into the now-famous decade-long Great Depression.
How does the “creation” of money affect the economy?
How does the Fed “create” money?
The Fed creates money through open market operations. When the Fed purchases securities in the market using new money, it creates reserves that are issued to commercial banks. Bank reserves are multiplied through fractional reserve banking. Banks can lend a portion of their reserves from the deposits they have on hand.
Tracking the amount of money out there is a very difficult process because many things can be counted as money. When considering what money is, most people think of paper bills and metal coins.
Savings and checking accounts represent direct and liquid money. Others are money market funds, short-term notes, and other reserves considered money.
The Fed uses open market operations, where it buys and sells Treasurys to add or subtract money. Short-term loans from the discount window are also available.
But the Fed’s number one way of creating money is to increase bank reserves. So, if the Fed wants to pump $1 billion into the economy, it simply buys $1 billion worth of Treasury bonds in the open market, thus creating $1 billion of new money.
Pretty simple, huh?
So when you hear on the news that the Fed is injecting $4 trillion into the economy, they are buying $4 trillion of Treasurys, thus creating $4 trillion of new money.
In the old days, they had to print dollar bills physically to add more money to the economy, all backed by the gold standard. Once that mechanism was removed, it enabled the Fed to use other means to create money, which it has done multiple times since the early 2000s.
Ok, let’s talk a little about the fractional reserve banking system. How does this work? Suppose the Federal Reserve adds $100 billion to the banking system. Nearly all of the $100 billion enter the commercial banking reserves. Now, banks don’t just sit on that money, even though they earn interest from the Fed. Most of the money is lent to businesses, private individuals, or governments.
Next, the credit markets become a funnel for the money distribution. Here is where the fractional reserve system comes into play. The new loans create more money. That new $100 billion in bank reserves could grow to $1 trillion.
Here’s how.
If the Fed issues $1 billion in reserves to the commercial banks, it, by law, can lend out $900 million, as they have to keep 10% in reserve. Once that money is lent out, it will eventually be deposited bank into the banking system, which can then be lent out again at 90%. This means that if $900 million is redeposited, an additional $810 billion may be considered deposits, which can be lent out again.
That initial $1 billion could grow to a total of $100 billion in new money for the economy through the fractional banking reserve.
Of course, all the money creation increases the Fed’s balance sheet.
Another example of creating money in the system is the monetization of debt.
A country can monetize its debt by turning it into credit or cash, which puts the debt on the Fed’s balance sheet.
The Fed monetizes the U.S. debt by buying Treasury bills, bonds, and notes. When the Fed buys these treasuries, it doesn’t create money; it issues credit to the commercial banks holding them and then puts them on the Fed balance sheet. Credit is treated like cash, another way of creating money.
How does the Fed monetize this debt?
According to thebalance.com:
“When the U.S. government auctions Treasuries, it’s borrowing from all Treasury buyers, including individuals, corporations, and foreign governments. The Fed turns this debt into money by removing those Treasuries from circulation. Decreasing the supply of Treasuries makes the remaining bonds more valuable.
These higher-value Treasuries don’t have to pay as much in interest to get buyers and this lower yield drives down interest rates on the U.S. debt. Lower interest rates mean the government doesn’t have to spend as much to pay off its loans, and that’s money it can use for other programs.
This process may make it seem as if the Treasuries bought by the Fed don’t exist, but they do exist on the Fed’s balance sheet, and technically, the Treasury must pay the Fed back one day. Until then, the Fed has given the federal government more money to spend, increasing the money supply and monetizing the debt.”
This leads us to the QE program instituted during the 2007 financial crisis.
Quantitative easing stimulates the economy by making it easier to borrow money. QE works when the Fed buys member banks’ mortgage-backed securities (MBS) and treasury bonds, increasing liquidity in capital markets. The Fed credits the commercial bank’s reserves as it buys the securities. QE increases the money supply and lowers interest rates; it is considered an expansionary monetary policy.
QE is another form of creating money for the Fed’s toolbox.
In the November 25, 2008, FOMC meeting, the Fed announced it was beginning QE1; it would buy $600 billion in bank debt, Treasury notes, and mortgage-backed securities from commercial banks. The QE was the Fed’s next tool after lowering the interest rates to near zero, and the economy was still not moving in the direction it wanted. By 2010, the Fed had purchased $175 million of mortgage-backed securities from the Fannie’s Mae and Mac. It also purchased $1.25 trillion from the big guns of the mortgage world.
The purchasing of the MBS was an attempt to offload the debts from the banks onto the Fed’s balance sheet, which more than doubled the Fed’s balance sheet. In 2010, the Fed stopped its QE1 program, as it looked like the aggressive actions had restarted the economy. However, a few months later, things started going south again, so they restarted the program.
QE2 started on November 3, 2010, when the Fed announced it would buy $600 billion of Treasurys to induce mild inflation to restart the stagnated economy.
QE2 kept rates low, which was good. The not-so-good part was that banks were still edgy about the economy, and instead of lending out their reserves, they were far more stingy and held onto those reserves.
Next was QE3 on September 13, 2012, when the Fed announced it would add $85 billion monthly to the economy. In this, the Fed did three things never done before:
- Kept the fed funds rate at zero until 2015
- Promised to keep purchasing securities until job creation increased substantially.
- Tried to boost the economy by whatever means necessary.
The next attempt was QE4, which began in December 2012. The Fed announced it would buy $85 billion in Treasurys and MBS and promised to continue this program until either unemployment fell to 6.5% or inflation rose to about 2.5%.
In December 2013, the Fed announced it would begin ending the QE by tapering security purchases. According to the Fed, it had met the three requirement targets it was shooting for.
- Unemployment was 7%
- GDP was between 2% and 3%
- Core inflation had stayed under 2%
In June 2017, the Fed announced it would begin unwinding its balance sheet by allowing the maturation of $6 billion of Treasurys each month without replacing them. It would follow a similar path for MBS, retiring $4 billion a month. These programs would be followed until Treasurys retired at $30 billion a month and MBS at $20 billion monthly.
So, did quantitative easing work?
Let’s list a few good things:
- Removed bad subprime mortgages from banks’ balance sheets
- Stabilized the economy by providing funds to restart the economy
- Kept rates low enough to restart the mortgage market.
- Stimulated the economy, probably not as much as hoped.
One of the undesired consequences of quantitative easing was creating a series of asset bubbles. It has also devalued the dollar as the dilutive effects of “more” money are added to the system.
Final Thoughts
Through our study of the Fed’s history, structure, and economic stimulus effects, we have seen that the U.S. central bank has great control over the economy.
They utilize many tools in an attempt to control the flow of money and credit, either to meet their goal of 2% inflation or to keep the economy stable with as much employment as possible.
We will see more economic stimulus from the Fed as we go through the economic effects of the coronavirus pandemic.
Where are we going to come out when this is all over? It’s hard to say, but a word of caution concerning the continuous creation of more money.
Think about the Roman Empire.
Why the Roman Empire? One theory about its decline and fall is that its money was devalued, starting with Nero and ending with the fall of the Western Empire.
What exactly happened? Well, at first, all coins used by the Romans, primarily the denarius, were one of the main coins used. The denarius was made of silver, but around the time of Nero, it began to be made with lesser metals than silver. This debasement meant that the denarius was worthless, and as the debasement grew, the denarius was worth less.
This cycle continued as the Empire grew, and economic challenges arose trying to fund the Empire; eventually, the denarius was worth almost nothing, and everyone’s wealth was destroyed.
As the money was worthless, the legions were not paid, and eventually, they left the army to find other employment, which weakened the borders and led to the eventual downfall of the Empire.
The bottom line is that too much devaluation of the dollar will weaken it to the point that it will no longer be worth buying anything.
Will all this happen tomorrow? No, but it is worth keeping an eye on and watching what transpires with the Fed.
That is going to wrap up today’s article.
Thank you, as always, for reading the article. I hope you find it valuable.
If I can further assist, please don’t hesitate to reach out.
Take care and stay safe,
Dave
