The Fed will decide the money supply. This will affect interest rates. – Twin towns

Tuesday’s meeting of the Federal Reserve’s Open Market Committee will be difficult.

The FOMC faces high measured inflation for the first time in more than 20 years just after Q1 2020 output fell after several quarters of strong growth. What does he have to do ? Finally tighten monetary availability after 15 years of slack unprecedented in the history of the world? Or once again give in to fears of recession?

Ed Lotterman

This is a loaded question. It has been evident for more than a decade that the zero interest rate policy adopted in the panic after the financial market crash of 2007-2009 had to come to an end sooner or later. The FOMC finally took a few baby steps, but then COVID-19 hit. Their response was unprecedented in Fed history, a 36% increase in the money supply metric called M2 over 24 months from March 2020 to March 2022.

The media, including the financial press, paid little attention to such a story. All of the reports focused on the FOMC’s target for “federal funds,” ie very short-term interest rates. After the debacle subsided, they had pushed the target to a level of 2.25-2.50% at the end of 2018, then fell again by 1.25 points before COVID. In March 2020, their target dropped to 0-0.25% effective until a quarter-point increase at the March 16 meeting, the last so far.

An air of inflationary panic has set in. There is a lot of talk about increases on this and at each of the remaining five meetings of 2022. This is an important public issue that deserves to be understood by the public.

Unfortunately, our central bank’s American reporters generally don’t have the levels of economic expertise common in England or Germany. Thus, the media often propagate and propagate misinformation that paralyzes rather than enhances public understanding. More often than not, it is by focusing on interest rates without mentioning the money supply and ignoring the key inherent links between the two.

A 2004 article opening with “Everyone knows the Fed sets interest rates. But most people don’t know that it can also change the money supply” has long been my classroom example of famous newspapers printing utter nonsense. Anyone who has followed an introductory macro has learned that the two are intrinsically linked. The first is only a signal, an indicator of changes in the second. Interest rates are to the money supply what a speedometer is to a fuel injector.

As the Fed increased the money supply in 2009, a common read was, “The Fed is doing something it’s never done before, buying government bonds to drive down interest rates.” If “never before,” how did the Fed come to hold some $650 billion in bonds, or nearly 5% of GDP, before the signs of turmoil in 2007? Why has an “open market committee” existed since 1935, if not for the Fed to buy and sell bonds on the open market?

So if you want to understand what’s happening on Tuesday and going forward, review some basics.

The Federal Reserve Act of 1913 established our central bank “to provide elastic money” that will benefit everyone. There will be a system of reserve banks. Why “book”? Because elastic money is stretched and contracted via bank reserves.

This is the fraction of their deposits, including yours and mine, that ordinary commercial banks have not lent. By law, in order for depositors to withdraw what they want and when they want, all banks must keep deposits in reserve. They can choose to hold more than that. Therefore, all must hold “required reserves” and may have “excess reserves”.

How are these reserves “held” by the banks? This can be physical currency, paper and coins, on the premises of the bank. The rest is in a “reserve account” that everyone must have in their regional Federal Reserve Bank. Checks and electronic payments pass through these regional Feds and are treated as transfers from the reserve account of one commercial bank to another. Thus, the reserves of the accounts vary from minute to minute throughout the day. But each bank must reach its required minimum at a specified time in the afternoon.

So there is a “federal funds” market. Banks that have more reserves than the minimum can lend them, overnight, to banks that are overdrawn. Of course, interest is paid. This is the “federal funds rate” used as a target by the FOMC as described above.

Note that the federal funds interest rate and any time of any day is not mandated by the Fed. It depends on supply and demand from minute to minute. But a central bank can increase and decrease the total amount of reserves in the system by buying or selling financial securities. In the textbook examples, these are US Treasury bonds, but in practice they are short-term contracts called “repurchase agreements” or “repos”. There are also “reverse repos”.

A repurchase agreement is the sale of a bond with the promise to buy it back at a specific time in the future. A reverse repo is the opposite side of the deal. In 1985, a colleague leaving to obtain a doctorate. sold me his 1972 Dodge Duster for $200. But I promised to resell it for $200 when it comes back three years later. For him it was a repo, for me a reverse repo.

Seen another way, I loaned him $200 and worked with rusty collateral. And if he had agreed to pay $210 to get his drummer back, he would have paid $10 in interest.

So what the FOMC needs to decide is how many of those buying versus selling it will make in order to push up overnight rates. The change will be minimal compared to the number of owners and the overall money supply that we have achieved over the past two decades.

As an added complication, what these Fed transactions change are reserves. Currency in circulation plus reserves make up the “monetary base”. This is related to the “money supply”, which is money plus deposits. The difference is therefore the deposits versus a portion of the deposits held as reserves. The Fed controls the monetary base but only influences the money supply because the ratio of supply to base varies with the activity of the banks. More on that next week. As homework, read several reports on his decisions announced Wednesday afternoon.

St. Paul economist and writer Edward Lotterman can be reached at [email protected]

About the author