How does the Federal Reserve create money?

Inflation arises from an environment where the number of dollars and credit outpace the goods and services available. In its simplest form, there are two ways to combat inflation, curb spending or expand supply. The Fed utilizes monetary tools in an attempt to increase or lower demand to balance the disparity between Supply/Demand. The biggest question currently is—Are the Federal Reserve’s policies having a tightening effect?

QE vs QT

I often hear people talk about the Fed’s money printer propping up the stock market, flooding the economy with dollars, and investors/consumers speculating or spending like drunken sailors. These comments are quite misleading and not helpful in explaining the mechanics of QE. The Fed is not inherently injecting money into the economy. Rather, they are creating the potential for those dollars to enter the economy by way of bank loan creation.

In simple terms, the Fed creates dollars by exchanging cash for bonds. Treasuries and other types of fixed income instruments are held on the Federal Reserve balance sheet, and cash is placed on the balance sheet of major banks. Through an electronic entry, bonds leave the banks’ balance sheets, and cash is credited in return. The idea is that the additional dollars and liquidity that a bank carries, the more it will seek to lend those dollars out in the form of loans. If the bank does not do this, it runs the risk of diluting its Return on Assets. As long as there are credit-worthy borrowers, by way of loan demand, there is a bank on the other side willing to dispense those dollars into the economy.

Banks are competing to create loans, but the main constraint of banks is that they must remain profitable. They cannot produce too many risky loans i.e., 2008, if they want to stay in business. As loans are reproduced, a stream of money growth is injected into the system, and the dollars are ‘born’. The Fed isn’t directly increasing the number of dollars in the system, instead they are creating the potential for those dollars to enter the economy.

Essentially, the bank acts as a ‘midwife’ in bringing those dollars to life. The main takeaway here is that money creation begins with the Fed, but loan origination is the main driver for those dollars to enter the system. Sure, Central Banks can certainly influence demand for loans by lowering the Fed Funds rate or through Open Market Operations.

However, the challenge is that if people are not willing to borrow, lowering rates is not necessarily going to help. An example is the more than 30 years that Japan has spent employing massive asset purchase programs like Quantitative Easing (QE). For three decades now, no real growth has occurred in Japan because Japanese consumers have basically refused to borrow. Now, to be fair, this is a multi-factor equation, and there are other contributors to Japan’s slow growth—like an aging population and poor private market competition born by poor policy decisions—but the point remains.

So, why didn’t we see rapid inflation post the 2008 Great Financial Crisis? This was largely because banks were limited to lending at this time as many were teetering on insolvency from 2008 and a contracting money supply. The Fed felt it necessary to step in and implemented Quantitative Easing (QE) to support banks and ensure money supply and reserves didn’t contract further.

In 2020, we saw manic borrowing through Coronavirus stimulus aid programs as corporations and small businesses alike borrowed out of fear, which can certainly cause inflationary effects (dollar creation via loans. We later saw additional CARES (Coronavirus Aid, Relief, and Economic Security Act) stimulus checks of $1,200 per eligible adult sent directly to individuals. The Fed acted as a lender not just to financial intermediaries but in this case to the end consumer. This distinction is especially important as it sidesteps the bank lending process and injects money directly into the economy via handouts straight into the hands of consumers. Some argue this had a more direct impact on the inflationary impact to the overall economy.

The Fed will deploy further monetary policy tools such as QE, which we have certainly seen in recent years. QE is deployed on a much larger scale and is intended to affect longer-term rates where they will enter in the open market and buy long tenured government debt, corporate debt, and asset backed securities (ABS). The application is the same, the Fed is creating reserves and using those reserves to buy securities in large quantities which removes those securities from the market, therefore impacting rates by lowering them (bond yields drop when prices increase), making it cheaper for companies to borrow.

QT

Take the Fed’s balance sheet and the handful of Treasuries that sit on their books – as those treasuries mature, they are rolled off the balance sheet (not reinvested). During a QT campaign, the US Treasury will issue new debt through the UST Auction and then use those proceeds to pay off the Fed. The money the Fed

receives from the Treasury sale proceeds are then evaporated from the system – they disappear. In essence, the dollars ‘die’ from the system via the Fed when this debt is repaid. From a supply and demand standpoint, this would cause there to be more US Treasury debt supply in the market which will create lower fixed income prices, and higher interest rates (again, there is an inverse correlation between bond prices and yields).

We are in a stage where everyone wants cash, but cash and liquidity are slowly being drained from the system – assuming everything else remains the same. If there is less cash available, when everyone desires cash, then a lot of those investors will sell their stocks and other assets to generate cash, which will result in lower stock and asset prices.

Reserves are removed at different paces, which is all determined by the Fed, and this can theoretically restrict the effect on bank lending. The reverse effect happens where it becomes more expensive to borrow dollars. This is brought into place to tighten spending or loan growth. The ultimate hope of the Fed is to destroy demand and bring more balance into place between supply and demand – combating the inflationary issue at hand.

The Current Credit Environment

In the earlier parts of 2022, we discovered that two measures of inflation, Personal Consumption Expenditures (PCE) and the Consumer Price Index (CPI) were both still rapidly accelerating despite the Fed’s best efforts to cause demand destruction through recent rate hikes. In August, we saw the consumption-weighted average price of goods and services by Americans increase 0.1% on a seasonally adjusted basis and rose 8.3% over the last 12 months, not seasonally adjusted. The data shows that households are continuing to borrow because of increases in nominal wage growth and historically high net worth values. As discussed earlier, this is particularly important as we know that money is created when banks produce loans – this new money flows through the economy and contributes to continually rising prices. Bank credit creation was high in 2021 and was off to a strong start in the early part of 2022.

Conclusion

Nominally, the spending fueled by wage and credit growth continues to grow at a high rate. This suggests that Fed policy may still be too accommodative since the Fed has been clear that their primary goal is tackling inflation. It is likely that rates are likely still too low as wage, credit, and wealth growth remains strong, meaning the Fed may feel the need to push back more aggressively against the market pricing in an attempt to retighten monetary policy. Being 100% risk-on / 100% risk-off or taking large one-sided bets is likely inappropriate especially in the current environment with so much uncertainty of money flow.