Fed reverse repurchases do not reduce money supply

August 5, 2021 3:26 p.m. ET


David Gothard

Phil Gramm and Thomas R. Saving present their editorial “How the Fed Is Hedging Its Inflation Bet” (August 2) stating a fact: “M2 money supply growth has increased from around 25% in 2020 to around 10% . % on an annualized basis in the first six months of 2021. They then explain that this deceleration occurred because the Fed has been able to drain “nearly a trillion dollars of liquidity out of the financial system” since April via its repurchase facility. Their argument is based on a flawed theory and does not hold water.

The idea that a trillion dollars in repo has reduced the money supply even by a dollar is absurd. Reverse repurchase agreements are a liability of the Fed and an asset of banks and money market mutual funds (MMMFs) which lend funds to the Fed through reverse repurchase agreements. Deposits from banks and money market funds are constituents of the money supply. These liabilities are unaffected by the choice of banks and money market funds to place their assets in the Fed’s repo facility, treasury bills, or elsewhere. Contrary to Gramm-Saving’s analysis, the Fed’s repo program has no effect on the money supply.

John greenwood

Chief Economist, Invesco


Teacher. Steve H. Hanke

Johns Hopkins University


MM. Gramm and Saving claim that “the interest payment on reserves allowed the Fed to borrow money from the banking system to buy treasury bills and mortgage-backed securities without expanding the money supply.” The Fed does not borrow from banks when it purchases assets; it creates the necessary money out of nothing. The Fed’s ability to pay interest on reserves is important, but not for the reasons cited by the authors.

They suggest that paying interest on reserves encourages banks to hold onto excess reserves rather than “using the excess.” . . increase loans. Banks as a whole must hold the reserves created by the Fed; they can lend them to each other, but to no one else. By paying interest on reserves, the Fed can free its interest rate decision from that of the size of a balance sheet to hold, thus obtaining an additional monetary policy tool. If the Fed paid no interest on reserves, as it did before the financial crisis, it wouldn’t be able to maintain a large balance sheet and aim for a non-zero fed funds rate.

Paul sheard

Harvard Kennedy School

New York

The article implies that the Fed made an intentional political decision to restrict the money supply by “borrowing” from financial institutions through reverse repurchase agreements (the temporary sale of government securities from the Fed’s vast holdings). It is misleading. The volume of reverse repo transactions is not determined by Fed policy, but rather by the demand of financial institutions for reverse repurchase agreements due to excess liquidity and the need for strong collateral. The Fed is not a borrower asking the financial markets for a loan. He is simply trying to maintain orderly financial conditions.

Em. Prof. Robert F. Stauffer

Roanoke College

Salem, Virginia

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Appeared in the print edition of August 6, 2021 under the title “Reverse Repos Don’t Shrink the Money Supply.” ”

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