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How Does the Federal Reserve Create Money?

Posted on November 2nd, 2022 -

A few weeks ago, I solicited FEE daily readers for their questions about economics. Pretty quickly I got a question I was pretty certain I’d get eventually. It comes from a man named Warren from Chicago who asks:

“what are the levers used by the Federal Reserve Bank to increase or decrease the money supply?

I know it has something to do with interest rates and bank reserves, but how does it actually take place and who receives all the extra money in circulation to cause the inflation?”

There are several channels that the Federal Reserve can use to create money, but I’m going to focus on the two most relevant ones: open market operations and interest on reserves.

The first way the Federal Reserve can increase the money supply is by creating more dollars. It’s not as simple as them printing dollar bills then throwing them out of a helicopter, though.

Instead, when the Federal Reserve wants to create money and put it into the system, it does so through banks. Banks hold several types of assets including treasury bonds. Treasury bonds are IOUs that the government issues in exchange for a loan. You buy a bond with cash today and the government promises to pay you back with interest in the future.

Banks like to hold treasury bonds because they’re viewed as low risk—it’s unlikely the US government will default on debt (any time soon at least). Treasury bonds also have the advantage that they’re relatively easy to sell to someone else to get cash. Economists call this ease of converting an asset into money liquidity.

The Federal Reserve offers to buy these bonds from banks. When the Federal Reserve buys bonds, they have an advantage you and I don’t. They are allowed to print new money to buy the bonds. It’s more likely that the money will be digitally created than literally printed, but the form of the money doesn’t make a difference.

The Federal Reserve acquires government bonds and banks acquire newly created money. The process doesn’t stop there, however. Banks don’t generally like to sit on large piles of money because money doesn’t earn interest (unlike the bonds they just sold to the central bank). So what do banks do with their money?

One thing they can do is make more loans to businesses. The increased supply of funds available to lend out means that there will be more loans available for the same number of businesses. Everything else held constant, this means the price of borrowing (the interest rate) will fall.

Banks can also turn around and buy more treasury bonds if they want to replace some of the bonds sold. This higher bond demand means the government will be able to take on more debt to finance its spending.

Economists call this process of the Federal Reserve using newly created money to buy bonds from private banks an open market purchase.

So how much has the Federal Reserve utilized this tool as of late? Look at this graph:

Figure 1: Treasury Securities Balances Held Outright

Since January 2020, The Federal Reserve has increased its treasury securities from $2.3 trillion to around $5.6 trillion today, an increase of around $3.3 trillion.

A more recent move by the Federal Reserve has been to purchase other types of assets as well. Before 2008, the Federal Reserve owned $0 in Mortgage-Backed Securities (MBSs). Today is a different story.

I won’t go into detail about MBSs (you can read more about them here) except to say they’re another type of financial asset banks hold which are a good bit riskier than treasury bonds. Here is a graph showing how Federal Reserve MBS holdings exploded in 2008 (in an attempt to alleviate the housing crisis) and again in 2020 (in an attempt to curb the negative effects of COVID policies).

Figure 2: Mortgage Backed Securities Held Outright

As you can see, the Federal Reserve acquired around $1.3 trillion worth of mortgage backed securities from January 2020 to today.

As economist Jim Gwartney pointed out for AIER,

“[the] $4.2 trillion increase in federal spending over the two [COVID] years was financed entirely by borrowing from the Fed. Fed holdings of financial assets, mostly Treasury bonds and mortgage-backed securities of federal housing authorities, increased from $4.2 trillion in February 2020 to $8.8 trillion in December 2021.”

So now we understand how the Federal Reserve creates new money, and who it goes to. Banks are the first recipient, and borrowers or those who sell financial assets banks demand (including the government itself) are the second recipients. And as Warren alluded in his question, this policy indirectly influences the interest rate.

There’s one other important tool for how the Federal Reserve can influence the creation of money. It’s a relatively new policy lever called interest on reserve balances (IORB).

To understand how the Federal Reserve impacts the money supply through IORB, you need to have a basic understanding of our banking system.

Let’s say Warren deposits $1,000 in his bank, FEEbank. What happens to the money then? In the United States, it’s unlikely that the money will sit in a vault. Instead, FEEbank will likely try to make a return on that money by lending some of it out to someone else.

So let’s say Jim comes and asks for a loan of $800 from FEEbank. FEEbank lends out $800 of Warren’s $1000. So how much money does Warren have? Well, when the bank lends out your money, your balance doesn’t go down. Warren can still go withdraw his money so long as the bank can give him deposits they’ve kept from other customers.

If everyone came to get their money at once, the bank would run out of money, but so long as that doesn’t happen, FEEbank doesn’t have a problem.

So now Warren has $1,000 and Jim has $800. There is now $1,800 in the economy compared to $1,000 before. FEEbank created more money!

The process doesn’t even have to end there. Jim can deposit the $800 in another bank, which can lend out a portion to someone else.

This system of banking is called fractional reserve banking because banks only keep a fraction of your deposits as reserves, and they loan out the rest.

So private banks in this system can create money by lending deposits, but what does this have to do with the Federal Reserve?

In 2008, the Federal Reserve adopted a policy of paying banks interest for the money they kept in reserves. So, instead of FEEbank loaning out Warren’s money, the Federal Reserve could offer to pay FEEbank to keep the money in the vault.

The higher the interest the Federal Reserve offers to pay FEEBank, the less likely it is to lend out the money. Why make a risky loan at a 3.5% interest rate if the Federal Reserve will pay you 3.5% for keeping it in the vault? The Federal Reserve is essentially paying banks to not make loans.

Notice, too, this also allows the Federal Reserve to more directly control the interest rate. If the Federal Reserve wants loans to have a 4% interest rate, all the agency has to do is promise to pay 3.9% IORB to not make the loan. In that case, a private borrower would have to offer at least 4% to beat the Federal Reserve.

So if the Federal Reserve wants banks to lend more of their deposits thereby creating more money, all they need to do is lower the IORB. And that’s exactly what they did during COVID.

In January 2020, the interest rate on reserves was 1.55%. By mid-March 2020, the Federal Reserve had dropped the rate to 0.1%.

This policy made it relatively more lucrative for banks to increase lending and, everything else held constant, when the benefits of an action goes up, people will do more of that action.

The result of these policies has been a large increase in the supply of money. Economists measure what counts as money a few different ways, but one of the most commonly used and accepted measures is called M2.

From January 2020 to January 2022, the M2 money supply increased from $15.4 trillion to $21.6 trillion.

That’s a 40% increase in the money supply— unprecedented in recent US history.

Figure 3: M2 Money Supply

As I’ve explained since May of last year, this increase in money supply inevitably led to higher prices across the board (aka inflation). FEE’s Dan Sanchez has explained this in depth as well.

Unfortunately, the Federal Reserve seems to have printed itself into a corner.

Utilizing open market purchases and lowering IORB may have propped up the economy by stimulating lending and investment in 2020, but the chickens are coming to roost. At this point, if the Federal Reserve wants to use its levers to bring inflation down, it’s going to do so by hurting investment opportunities.

As of this month, the IORB has been raised to 3.15%. This means less funds will be available to borrowers. Whether we’re in a technical recession or not right now, it seems unlikely to me the Federal Reserve will be able to bring inflation down without allowing an economic correction to take place.

There’s no such thing as a free lunch. Printing dollars does not mean there are more sandwiches to go around. And although the Federal Reserve can affect the economy with their levers, they cannot print prosperity.

This article was authored by Peter Jacobsen and originally appeared here.

Image Credit Pxhere|CC0 1.0 Public Domain