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How Fed Economic Stimulus Works and Its Effect on the Economy

The central bank of America is the Federal Reserve, and the Fed has the responsibility of deciding how much money there 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 amount of 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 at this time to discuss the effect of the Fed on the economy and 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 am writing this article on March 26, 2020, we are in the throes of the Coronavirus pandemic that has taken the world by storm. The virus has disrupted life as we know it and cost, at this point, thousands of people their lives.

It has also thrown the world’s economies into shambles, with multiple countries either planning on some sort of 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 sort of political ideology. The information I am going to share with you is purely from the aspect of how the system works, not whether it is right or wrong. That is for others far better educated than me to decide.

Items we will discuss in the article:

  • How the Fed Prints Money
  • Another Way the Fed Creates Money
  • The Dual Mandate
  • Expansionary Monetary Policy
  • Contractionary Monetary Policy

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 the lower scale, which corresponds with low inflation.

When interest rates are low, this allows businesses to borrow money to grow, and increasing payroll to match this growth. In this environment, employment is low, and the economy is allowed to grow.

When prices are stable, it allows consumers to buy with confidence, 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)

In regards to inflation, the Fed sets its goal at 2 percent. When the Fed sets policy, it is looking to the long-run, not short-term. Some of their policies may affect in the short-term, but the long-term is their goal.

They must look to the future and attempt to head off inflation or deflation at the pass, 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 is the prices falling throughout the economy, such that the inflation rate is negative. When the inflation rate falls below zero is a deflationary period.

Think of the deflation as a period when your dollar goes farther as the prices of goods and services fall. It is also a time of monetary contraction, meaning that the supply of money and credit are 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 the next year 9%, now 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 on a downturn. Think today, as 3.3 million people file for unemployment, the largest amount in our country’s history.

The Fed has been tasked with keeping maximum employment and can use any of its monetary tools at its disposal as the economy worsens.

Bottom line, the Fed has a difficult job of juggling both pricing stability and maximum employment. If the Fed focuses on one aspect, the other could falter, and vice versa. The FOMC, we discussed last week has to be mindful of the road ahead at all times.

Expansionary Monetary Policy

In today’s economy, with the threat of recession, we are entering a phase of expansionary monetary policy.

Expansionary monetary policy is when the Fed uses all of its tools to jump-start the economy. It is usually done in a time of recession, think the Great Recession of 2007 to 2009.

The expansionary monetary policy increases money in the economy, lowers interest rates, increases demand. Not all of these happen at once; they are usually cumulative effects.

One aspect is not talked a lot about with this policy; it decreases the value of the currency. This point we will come back to in time.

The Fed’s most used tool for creating expansionary policy is to use the open market operations. That’s when they buy Treasury notes from its other member banks; to do this, the Fed simply creates credit.

Where does it get the money to do this?

More on that in a moment.

By the Fed replacing the banks’ Treasury notes with credit, the Fed gives them more money to lend out to businesses or consumers. To make the credit more appealing to consumers, they offer lower interest rates. All of this makes loans for cars, businesses, and mortgages less expensive. Credit card rates are also lowered with this process. All of this cheap credit boosts spending, or that is the theory and puts more “money” back in the system.

Another tool, the FOMC may use is the Fed funds rate. If you remember, this is the rate that 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 that have more than they need in reserve will lend that money out to each other, to those that don’t have enough money, and it will be charged at the fed funds rate.

When the Fed funds rate drops, this gives banks cheaper money to hold in their reserves, and in turn, 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 it borrows from its discount window. Using this rate is something of a last resort for banks because there is a stigma attached.

The Fed is considered a lender of last resort, and banks will only use the discount window when it can’t borrow from any other consumer banks.

A new fourth tool, created during the Great Recession is interest on reserves. Congress granted the Fed this new tool after 2007-2009.

Interest on reserves is money paid on excess reserves held in the Reserve Banks. Recall that 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 reserves the consumer banks hold. 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. Contractionary monetary policy is used by the Fed to fight inflation, which occurs when the economy is a runaway train.

The bottom line is the Fed will raise interest rates, which helps slow the economy and create less liquidity. Raising the rates will make lending more expensive, which will reduce the money and credit that banks are willing to lend. In turn, 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 steps in and attempts to slow that demand by making purchases more expensive. By raising the bank lending rates, which makes all borrowing more expensive, such as mortgages, car loans, and credit cards. All of this puts a dampening effect on the 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.

To initiate contractionary policy, the Fed begins selling Treasury Notes to the consumer banks, and the bank must pay the Fed for these Treasury Notes, which leads to having less money to lend. The result of 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 the interest rates. As you might recall, this rate is the rate that each bank is charged to hold a reserve overnight to meet their 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 will rarely utilize the discount window, even though the rates are lower than the fed funds rate. The reason for this is because 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 put a stop to the hyperinflation of the last 1920s. Bernanke stated that during the stock market crash of 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 reason the Fed continued that policy was that 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 the use of open market operations. When the Fed purchases securities in the market using new money, they are creating reserves that are issued to commercial banks. The Bank reserves are multiplied through fractional reserve banking. Banks can lend a portion of the reserves of the deposits they have on hand.

A very difficult process is tracking the actual amount of money out there because many things can be counted as money. Paper bills and metal coins are what most people think of when considering what is money.

Savings and checkings accounts represent direct and liquid money. Others are money market funds, short-term notes, and other reserves are considered money as well.

The Fed uses the open market operations where it buys and sells Treasurys to add or subtract money. Also available are short-term loans from the discount window.

But the number one way the Fed creates money is to increase the bank reserves. So, if the Fed wants to pump $1 billion into the economy, they simply buy $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, this means that they are buying $4 trillion of Treasurys and thus creating $4 trillion of new money.

In the old days, they had to physically print dollar bills to add more money to the economy, which was 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 this works, 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 are earning interest on that money from the Fed. Most of the money is lent out to either business, 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 actually create more money. That new $100 billion in bank reserves could potentially 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, then an additional $810 billion may be considered deposits, which in turn can be lent out again.

Through the fractional banking reserve, that initial $1 billion could grow to a total of $100 billion in new money for the economy.

Of course, all the creation of money increases the Fed’s balance sheet.

Another example of creating money in the system is the monetization of debt.

The country can monetize it’s dept when it turns debt to 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 Treasurys, it doesn’t create money; it issues credit to the commercial banks that hold these Treasuries and then puts it on the Fed balance sheet. The credit is treated like cash, another method 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 that was instituted during the 2007 financial crisis

Quantitative easing is used to stimulate the economy by making it easier to borrow money. QE works when the Fed buys mortgage-backed securities (MBS), and Treasurys from the member banks. All of this increases liquidity in capital markets. The Fed issues a credit to the commercial bank’s reserves as it buys the securities. QE increases the money supply and lower interest rates; it is considered a form of 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 begin buying $600 billion in bank debt, Treasury notes, and mortgage-backed securities from commercial banks. The QE was the Fed’s next tool to use after they had lowered 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 to the Fed balance sheet. In turn, this more than doubled the Fed’s balance sheet. In 2010, the Fed stopped its QE1 program, as it looked as the aggressive actions had restarted the economy, but a few months later, things started going south again, so they restarted the program.

QE2 started on November 3, 2010, when the Fed announced they would buy $600 billion of Treasurys with the goal of inducing mild inflation to restart the stagnated economy.

The QE2 was able to keep rates low, which was good. The not-so-good 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 a month to the economy. In this, the Fed did three things never done before:

  1. Kept the fed funds rate at zero until 2015
  2. Promised to keep purchasing securities until job creation increased substantially.
  3. Tried to boost the economy, in whatever means necessary.

The next attempt was QE4, which began in December 2012, when the Fed announced it would buy a total of $85 billion in Treasurys and MBS. They promised to continue this program until either unemployment fell to 6.5% or inflation rise to about 2.5%.

On December 2013, the Fed announced it would begin ending the QE with a tapering of 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. And with a similar path for MBS, it would retire $4 billion a month. Both of these programs would be followed until Treasurys were retiring at $30 billion a month and MBS at $20 billion a month.

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 the creation of a series of asset bubbles. It also has devalued the dollar as the dilutive aspects of “more” money is added to the system.

Final Thoughts

We have seen through our study of the history, structure, and economic stimulus effects of the Fed 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 to either meet their goal of 2% inflation and keep the economy stable with as much employment as is possible.

We are going to see more economic stimulus from the Fed going forward as we go through the economic effects of the coronavirus pandemic.

Where are going to come out on when this is all over, 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 of the theories about the decline and fall of the Roman Empire is the devaluing of their money, starting with the time of 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, 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. And this debasement meant that the denarius was worthless, and as the debasement grew, the less the denarius was worth.

This cycle continued as the Empire grew, and economic challenges arose trying to fund the Empire; eventually, the denarius was worth almost nothing, and the wealth of everyone 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 too much devaluation of the dollar will weaken it to the point that it won’t have any value to buy 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. You can read some of the previous articles I”ve done on the Fed here:

Thank you as always for taking the time to read the article, and I hope you find something of value.

If I can be of any further assistance, please don’t hesitate to reach out.

Take care and be safe out there,

Dave