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Reprinted with permission•Mises Wire•Tom Mullen
Since September, Jerome Powell’s Federal Reserve System has been cutting rates as if a financial crisis were looming. Just as in 2006, Powell raised the federal funds rate to 5.25 percent in the summer of 2023 and left it there until September of the following year. This past September, he cut rates by 50 percent in September and by 25 more basis points at the following Fed meeting just as Fed Chairman Ben Bernanke did starting in September 2007. We all know what happened next.
That’s where the similarity ends, however, when it comes to overall monetary policy. When Bernanke started his cuts in September 2007, he did so the way the Fed had always done so: open market operations. The Fed began buying government securities from its member banks, thereby increasing the supply of dollars available to those banks, which forced the federal funds rate down. That’s not the way it’s done anymore.
After Bernanke embarked on what he euphemistically called “quantitative easing,” which is basically doing the same open market operations on steroids, a new dynamic emerged. Since the member banks accumulated large deposits at the Federal Reserve—something they never had before—interest rate policy became separated from management of the money supply.
No longer did the Fed accomplish a lower fed funds rate by buying securities to supply member banks with more dollars. It now could simply lower the interest rate it paid on member bank deposits at the Fed to incentivize member banks to lend to each other at a lower rate. Doing so without actually increasing the base money supply will encourage commercial bank lending but does not have the exponential effect that both lower interest rates and more “base money” can have.
Commercial banks also create money when they lend on a fractional reserve, but it is limited compared to the money created by the Fed. If the Fed lowers interest rates, commercial banks are incentivized to make more loans, creating new money, but that money is “destroyed” once the loans are repaid. Thus, commercial bank monetary inflation reaches an equilibrium point, with occasional deflations, if the Fed doesn’t change the money supply.
The same money creation and destruction dynamic applies to the Fed itself but on a much larger scale. Money is also destroyed when loans held by the Fed are paid down, thus decreasing the base money supply. But the Fed has always been a net creator of money over the long term, which is why consumer prices have always increased over the long term.
That brings us to today, where the Fed seems to be “unburdened by what has been,” as Vice President Kamala Harris would say. That’s because, unlike in autumn 2007, when the Fed’s balance sheet increased by necessity to achieve its first two rate cuts, its balance sheet has decreased since beginning cuts this past September. This is just continuing the monetary tightening the Fed began in 2022 when its balance sheet peaked at $8.9 trillion. Through August of 2024 it has reduced its balance sheet to $7.1 trillion and kept on reducing it right through its September and November rate cuts to $6.9 trillion, where it stood as of its November 21, 2024 release.
So, the Fed is lowering the federal funds rate while decreasing the money supply. So, is it loosening or tightening? One could make an argument either way and it gets even more complicated than that.
During the two years starting March 2020, when the Fed kept interest rates near the zero bound, it increased its balance sheet from around $4 trillion to almost $9 trillion. This was unquestionably loosening as both interest rates and money supply were accommodative. But then, Powell added a third variable.
About a year into this massive loosening, Powell raised the interest rate paid on Reverse Repurchase Agreements. These “reverse repos” are the opposite of what is commonly called “the repo market.” The repo market allows banks to sell securities to the Fed on a very short-term basis—from 24 hours to two weeks—at which time they buy them back (“repossess” or “repo” them). It’s basically a way for banks in a bad spot to borrow money from the Fed without the market stigma attached to the now useless Fed discount window.
The reverse repo market allows banks to do precisely the opposite: to buy a security from the Fed on a short-term basis, thus technically lending cash to the Fed at interest. Normally this market exists for extremely technical reasons and has a negligible volume of money tied up in it. However, interest rates at the zero bound creates a problem for the money markets, which Powell solved by raising the rate in the repo markets.
Between January 2021 and June 2023, this market went from ostensibly zero to over $2.2 trillion. This meant that Powell’s $5 trillion monetary tsunami was now decreased by $2 trillion as those dollars basically bounced back and forth between the Fed and banks, unavailable for other uses. So, the Fed’s monetary expansion was significantly muted by this reverse repo effect.
Predictably, as interest rates rose, making more yield available for money markets, the reverse repo market volume decreased. Interestingly, it has decreased since June 2023 almost precisely the same amount (around $2 trillion) that the Fed’s balance sheet has decreased.
So, until this moment, there has effectively been no monetary tightening at all. This might explain why “nothing has broken” during the Fed’s interest rate increases over the past two and a half years. It has increased interest rates to something closer to what it calls “neutral,” but it hasn’t effectively decreased the money supply significantly. The M2 money supply index confirms this. Yes, there was a decrease after the $21.7 trillion peak, but it was negligible compared to the over 40 percent increase from February 2020 to that point. It has now given half of that decrease back.
But now, the Reverse Repo Market cushion is almost gone. It sits at about $200 billion as of this writing. The question for the Fed is whether it wants to begin really tightening by continuing to decrease its balance sheet without the accompanying reduction in base money for the economy being offset by money leaving the reverse repo market. If it does, then what is its policy? It would be tightening money while loosening interest rates. Or will it again abandon its promise to return its balance sheet to “normal” and begin buying securities again to at least coincide with its loosening interest rate policy?
If the Fed truly tightens money and interest rates, it will break an economy that has become addicted to artificially-low interest rates. It will also bankrupt the federal government, which has to pay interest on over $30 trillion in debt and counting. If it truly loosens money and interest rates, it will reignite price inflation at rates that will eclipse those seen during the Biden years. Therefore, it may try to do both at the same time: lower interest rates and decrease the money supply. Perhaps this schizophrenia should be expected when the central bank model finally reaches that point where no policy can possibly work.
Whatever the Fed decides to do next, proponents of leaving both the money supply and interest rates to a free market may finally get their chance to say, “I told you so.” Unfortunately, that opportunity will be served with a lot of economic pain.
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