FOMC today, Fed widely expected to hold rates as-is; let’s talk money supply

Today the Fed announces its latest rate policy, and the market consensus is that rates will remain unchanged in the backdrop of high growth and sticky inflation.

Let’s talk about how the Fed actually creates money and grows or shrinks the money supply. When we say it “prints money”, this, of course, is now an expression, as the physical printing of money is becoming a smaller and smaller share of the actual money supply.

In reality, the Fed needs the banking system and private markets in order to carry out its policy, and here are some of the ways it does that:

Through open market operations

The biggest banks in the US are designated as “primary dealer banks”. Currently the list includes 24 of the largest banks in the US, including heavy hitters like JP Morgan, Goldman Sachs, Bank of America, Citi, Morgan Stanley, Wells Fargo, and others.

These banks have the privilege of dealing directly with the Fed for funding needs, but critically they are obligated to buy and sell securities with the Fed under the prevailing Fed policy.

What’s this mean in plain terms? If the Fed wants to increase the money supply, it will instruct the primary dealer banks that their trading desks must sell securities to the Fed (like treasury bills, but they can also be other securities like mortgage backed securities). The banks in turn will receive cash from the Fed. This is why you will hear that the Fed’s balance sheet is growing during expansionary monetary policy, because it keeps buying securities from banks in order to expand the money supply, and the Fed is now holding onto a large pool of securities. Currently, the Fed’s balance sheet is almost $8 trillion.

On the flip side, if the Fed wants to tighten the money supply, it will instruct the member banks that they must buy securities (like treasury bills) from the Fed. The Fed will unload securities to the banks at current market prices, and in turn take cash from the banks. This is why in the current environment you’ll hear questions about the size of the Fed’s balance sheet, as traders try to get a sense of the direction using this information. The Fed has also said numerous times that it will shrink its balance sheet by letting held securities run off, in other words, if it holds a treasury bill or mortgage backed security that matures, it doesn’t replace the security, it just allows it to expire.

Through fractional reserve banking

Fractional reserve banking is how banks make money. In essence, a bank will lend out the deposits it receives, which creates more money in the system. Let’s use a very simple example using this graphic. Bank customer John has $1,000 and deposits in into his bank. The money supply is unchanged. The bank will then make a loan to another customer for $500. The borrowing customer now has $500 that she didn’t have before, the bank created this $500 for her and the system, using the $1,000 deposit as a funding source.

Now in our example, the money supply in this microeconomy has increased from $1,000 to $1,500. Banks never hold the entirety of deposits in a vault, they lend it out, and that’s how they are able to afford paying interest on deposits. They give back to you a portion of what they receive for their loans, known as a spread. In this example of two customers, you could rightly ask what happens if the depositor comes back asking for his money? The bank would be in trouble because it would have to wait for the loan to be paid back in order to have enough cash on hand to fulfill the deposit. In reality, big banks manage millions of transactions, and manage their cash inflows and outflows very tightly. However, it’s not without risk, as “bank runs” throughout history are exactly this: depositors rush to get money back, more money than the bank has on hand.

Now extrapolate this example out exponentially from the Fed to the primary dealer banks to smaller banks and to businesses and consumers, and you can see how the money supply expands in low interest rate environments. It encourages this type of lending and credit activity, which can increase the money supply dramatically

Picture credit to coursesidekick.com

Again, on the flip side, when interest rates are increased, the goal is that banks will lend out less and less money, which would slow the expansion of the money supply over time.

So the Fed’s goal with current interest rate policy is to foster the right lending environment where banks will make fewer loans, tightening the money supply. Because growth is still strong, it can comfortably do so, since a higher rate environment doesn’t seem to be slowing the economy down at the moment.