By Frank Shostak*
In an exchange with readers on Time magazine’s website on December 22, 2010, the Fed chief – at the time Ben Bernanke – was asked why the Fed is creating dollars “out of thin air”. His response was that the Fed does not print money.
In addition, since the early 1980 the Fed no longer pays attention to the quantity of money as such but rather sets a target to interest rates. This further reinforces the view that the Fed has nothing to do with the active generation of money “out of thin air”.
Furthermore, it is held by most experts that by setting the target to interest rates, the Fed is only accommodating changes in the demand for money so in this sense this accommodation does not result in an effective increase in money supply.
In truth, the Fed is the key for the generation of money out of “thin air”, notwithstanding that it does not target any longer the quantity of money but rather interest rates.
Interest-Rate Targeting as the Vehicle for Money Generation out of “Thin Air”
The main market through which the Fed manipulates interest rates is the Federal funds market. Commercial banks keep a portion of money that is deposited with them with Federal Reserve banks. The money that commercial banks maintain with the Fed is labeled as reserves.
Observe that the money kept by banks as reserves are not part of the money supply. The money kept in reserves is withdrawn from the economy and for this reason it is not part of the money supply.
Banks require reserves in order to meet their reserve requirements and in order to be able to clear financial transactions. When checks written against a bank are presented, the bank must have the money to honor those checks.
On any particular day there are some banks that have more reserves than they require i.e. they have excess reserves. Conversely, there are banks that have far too little reserves i.e. they have a deficiency of reserves.
The existence of excess and deficient reserves among various depository institutions sets a platform for a market for these reserves, which is labeled as the Federal funds market. The interest rate charged for the use of Federal funds is called the Federal funds rate.
The US central bank aims towards bringing the Federal funds rate to a particular level, or target, which it believes will enable the central bank to achieve its objective of stable, non-inflationary economic growth.
Once the target is set, it is the role of the Federal Open Market Desk to make sure that the target is maintained. As a rule, once the target is announced the market tends to bring the interest rate towards the target in anticipation that the Fed will be successful in achieving its goal.
To succeed in keeping the rate at the target, the Fed’s Open Market Desk monitors various factors that have the potential to disrupt the balance between the supply of and the demand for Federal funds. Once these disruptive factors are identified, Fed operators counter them by means of buying or selling assets in the market.
When individuals pay taxes to the Treasury the payment of taxes is done by transferring money from taxpayers’ demand deposits with their banks to the Treasury deposit with the Fed.
This result in an increase in the Treasury account with the Fed and the reduction by the corresponding amount of cash held at demand deposits with the banks. Note that the payment of taxes does not have effect on the money supply.
When a taxpayer pays $1000 in tax to the Treasury, his money, e.g., $1000, is transferred to the Treasury — there is no change in the money supply.
Because of this transfer of money to the Treasury account, banks will now have less cash i.e. reserves in their possession. Hence, what we have here is a decline in the supply of Federal funds.
The fall in the supply of Federal funds, all other things being equal, puts upward pressure on the Federal funds interest rate.
In the absence of Fed intervention, the Federal funds interest rate in the market will tend to rise above its target. In order to protect the federal funds rate target due to a decline in reserves, the Fed will initiate the buying of assets in the market now in order to add to the supply of federal funds.
If the Fed buys assets from non-banks then this raises the supply of money through the increase in demand deposits.
The collection of taxes by the Treasury therefore, results in an increase in the money supply once the Fed buys assets in the market from non-banks in order to keep the fed funds rate at the target.
Now, if the Fed buys assets from banks, then we will have an increase in banks reserves without the corresponding increase in money supply. The buying of assets in this case will amount to the transfer of money to banks deposits with the Fed i.e. an increase in reserves.
Conversely, when the Treasury spends the money – i.e. its deposits with the Fed decline – this raises banks’ reserves and thus raises the supply of Federal funds.
As a result, for a given demand this puts downward pressure on the Fed funds rate. To prevent the federal funds rate from falling below the target the central bank initiates the sales of assets, thereby removing money from the economy . Obviously, no effect on money supply will take place if the central bank sells assets only to banks.
Changes in Demand for Cash
Another potential disrupter of the Fed funds target rate is changes in the demand for cash. Consider the case when individuals increase, for whatever reason, their demand for cash. Because of this increase in demand, which banks accommodate, the amount of cash that banks hold with the Fed is reduced.
Consequently, there is going to be less supply of federal funds and within all other things being equal, an upward pressure on the fed funds rate is going to emerge. To sustain the fed funds rate target the US central bank is compelled to inject new money into the market by buying assets.
Note that when the banks accommodate this increase in the demand for cash, this leads to the transfer of cash from bank reserves to people’s demand deposits. This results in the increase in money supply. (Note again that money in reserves are not part of money supply).
To arrest the upward pressure on the fed funds rate, the US central bank pumps money through buying assets. If the assets are bought directly from non-banks then this will lift the money supply further. Hence, what we have here is an increase in money supply because of the transfer of cash to people’s demand deposits.
We then have another increase in money supply because of the Fed’s buying of assets in order to keep the federal funds rate at its target.
The increase in the demand for cash sets a corresponding increase in the money supply, which is followed by another increase in the money supply once the Fed, in order to keep the Federal funds rate at the target, buys assets from non-banks.
Conversely, if individuals’ demand for cash falls, all other things being equal, this results in the decline in money supply.
Strong Economic Activity & Crises
Another source of a potential disruption to the Fed’s policy of setting its interest rate target is the situation of a strengthening economic activity. The consequent increase in demand deposits due to a strengthening in banks’ lending now requires more reserves, which in turn leads to a strengthening in the demand for Federal funds.
In this situation, the Fed is required to intervene in order to prevent the Fed funds rate from increasing, and it does so by buying assets. If the Fed buys from non-banks this leads to the increase in the money supply.
In addition, in times of economic crisis the chase for liquidity by financial institutions can put strong upward pressure on the Fed funds rate. In this case, in order to prevent the rate from rising strongly above the target the Federal Reserve initiates a significant buying of assets – it boosts the supply of Federal funds in line with the strong increase in the demand for these funds. If it buys the assets from non-banks then this leads to the increase in money supply.
Funds Repatriation by Multinationals as a Source of Money Creation
Apart from the Fed buying assets and fractional reserve banking, another source for the increase in money supply can be through funds repatriation by multinationals.
For instance, if an American company decides to transfer its overseas earnings back home then this will result in an increase in the US money supply.
Observe that at any point in time there is a given pool of US dollars. In the absence of the Fed’s monetary pumping and in the absence of banks engaging in lending out of “thin air” i.e. fractional reserve banking, no expansion in the pool of dollars can emerge.
Notwithstanding the given pool of US dollars, the transfer of money by multinationals amounts to transferring dollars out of the non-US bank dollar reserves that are kept at the Fed to a demand deposit at a US bank.
This means that because there is a shift of dollars out of foreign bank US dollar reserves that are kept at the Fed, (note that these reserves are not part of money) to demand deposit, this result in an increase in money supply by the amount of the money repatriated.
If the transferred money is then used to purchase Treasuries then this will lift the Treasury cash balance at the Fed. This however, will not have further effect on money supply, all other things being equal. (The money has now shifted from the demand deposit account to the Treasury cash balance account).
Since the early 1980, the Fed no longer pays attention to the quantity of money as such but rather sets a target to interest rates.
It is held by most experts that by setting a target to interest rates the Fed only accommodates changes in the demand for money so in this sense this accommodation does not result in an effective increase in money supply. This is due to the belief that a given increase in the demand for money neutralizes the corresponding increase in the supply of money
This reinforces the view that the Fed has nothing to do with the active generation of money “out of thin air”.
But, in practice Fed is central to the generation of money out of “thin air” notwithstanding that it does not target any longer the quantity of money but rather interest rates.
This article was published by FPRI.