If the Federal Reserve has printed over $2 trillion dollar and given it to banks to lend, why is U.S. inflation still low?
In this episode you’ll learn:
- How banks create money and how reserves factor in to banks’ lending decisions.
- How much has the money supply increased as a result of bank lending and Federal Reserve action.
- How Federal Reserve bond buying increased liquidity but not national wealth.
- Why we haven’t seen higher inflation.
Many people wonder if the Federal Reserve is really printing money. Varied schools of thought exist behind the value of money, how it gets injected into a country’s economy, and how it impacts the private sector. On this episode of Money For the Rest of Us David offers insights into this complex subject, all while giving you the best information regarding the Federal Reserve, its open market operations, bank reserves, and why we aren’t experiencing hyperinflation. It’s sure to be an educational episode that you don’t want to miss.
Can the Federal Reserve create money without printing it?
The US Federal Reserve is not able to produce physical money in the form of coins or bills. That’s the responsibility of the US Treasury, their Bureau of Engraving and Printing, and the US Mint. The Federal Reserve, however, can “print money” when it purchases U.S. Treasury bonds with money it creates by adding to its member bank reserves.
Kimberly Amadeo, a writer at The Balance, explains this buying/selling of US treasuries by saying, “One of the Fed’s tools is open market operations. The Fed buys Treasuries and other securities from banks and replaces them with credit. All central banks have this unique ability to create credit out of thin air. That’s just like printing money.”
How do banks create money for individual borrowers?
Contrary to what many believe may happen, banks do not transfer money from a different account or withdraw it from a central vault for loans. Rather, David explains that banks “create money out of nothing” and withdraw it when loans are repaid. Thus, excess central bank reserves are not a necessary precondition for a bank to grant credit and therefore create money. Banks typically only have to have 10% of all accounts in reserves. If a bank lacks the reserves to cover the payments, it can be borrowed from an inter-bank market or central bank system.
Why haven’t we seen hyperinflation due to these processes?
The United States hasn’t seen an influx of hyperinflation because the private sector hasn’t been willing to borrow enough funds to strain the current capacity of the economic machine. David further explains the lack of inflation by using the two money aggregates that exist in the US: M1 and M2. M1 is composed of currencies, paper, bills, notes, traveler’s checks, and checking accounts (demand-deposits). M2 is made up of everything in M2 plus savings accounts, CDs, retail money market funds, etc. In March 2009, at the height of the recession, M1 levels were around $1.6 trillion. As of April 2018, the M1 was at $3.7 trillion – a 130% increase! Does this mean households are wealthier? Not necessarily. The majority of them simply have more liquidity, because Treasury Bonds were sold to the Federal Reserve in exchange for checking account deposits.
[1:15] Is the Federal Reserve really printing money?
[6:40] Two ways to address this question
[11:50] So how do individual banks create money for borrowers?
[21:20] Monetary aggregates in the US and how they indicate the level of wealth and liquidity
[23:50] Why hasn’t this led to hyperinflation?
Welcome to Money For the Rest Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is Episode 205. It’s titled: Is the Federal Reserve Really Printing Money?
Money Is Minted From Trust
In April 2017, Deputy Governor Jon Nicolaisen of the Norwegian Central Bank gave a speech to the Norwegian Academy of Science and Letters. In his talk he quoted the book, Sapiens: A Brief History of Humankind. It’s by Yuval Noah Harari. I’ve not read the book. Others have recommended it, and just based on this quote, it makes me want to read the book. He writes, “Trust is the raw material from which all types of money are minted.” That’s a theme I’ve covered on the show a lot, specifically Episode 84, Money Is Trust. But he continues, “The fact that another person believes in cowry shells, or dollars, or electronic data, is enough strengthen our own belief in them. Christians and Muslims who could not agree on religious beliefs could nevertheless agree on a monetary belief, because whereas religion asks us to believe in something, money asks us to believe that other people believe in something.”
And then, Deputy Governor Nicolaisen goes on to say, “Money has value because and only because everyone believes in its value. Money is minted from trust.” This idea that money asks us to believe that other people believe in something reminds me of Ben Hunt. I think he’s the Chief Investment Strategist at Salient Partners. He writes a newsletter called The Epsilon Theory, and one of his ongoing themes is this idea of the common knowledge game that investment markets, the narrative gripping the market depends on, what does everyone know that everyone else knows? Or, what does everyone believe that everyone else believes? And, how do they act on those beliefs?
How The Fed Prints Money
In Episode 201, I quoted extensively from the book, Balanced Asset Allocation. It’s by Alex Shahidi. But there was one aspect of the book I didn’t quote from because I knew I just didn’t want to go down that rabbit hole. Here’s the quote: “The Fed, as in the U.S. Federal Reserve or the Central Bank, has the unique ability to print money and buy assets. It can essentially create more money and inject it into the economic machine.”
This idea the Fed can print money, I had a number of discussions on this while I traveled for the past couple months. This is a common belief. Does everyone know that everyone knows that the Fed prints money? And that will lead to high inflation, or hyperinflation eventually?
If you Google, and I did, Google the phrase, “Is the Federal Reserve printing money?” The top of the list on the first page is an article by Kimberly Amadeo in an online magazine, I guess, called The Balance. I had not heard of it. Here’s what she writes, here’s her explanation to answer this question, is the Federal Reserve printing money?
“When the Fed wants to print money, it lowers the target for the Fed funds rate. Fed funds are what banks are required to hold and reserve each night. If needed, a bank will borrow Fed funds from another bank to meet the requirement. The interest rate it pays is called the Fed funds rate. When the FOMC, the Federal Open Market Committee, lowers the target for the Fed funds rate, it allows banks to pay less for borrowed Fed funds. Since they are paying less in interest, they have more to lend. A bank would like to lend every dollar it doesn’t have to hold in reserve.”
Do banks lend reserves? Is the Fed printing money in the form of creating reserves that banks have, and then banks can lend?
She goes on, “When people say the Federal Reserve prints money, they mean it’s adding credit to its member banks’ deposits. The Fed buys treasuries and other securities from banks and replaces them with credit. All Central Banks have this unique ability to create credit out of thin air. That’s just like printing money.”
A little further down that first page of Google results is an article by the St. Louis Federal Reserve. They write, “One of the most common questions about the Federal Reserve is, does the Fed print money? There are really two ways to address this question in terms of the actual physical printing. No, the Fed doesn’t actually print or produce money in any form.” They point out that the coins come from the U.S. Mint. Paper currency comes from the U.S. Treasury Bureau of Engraving and Printing. So the Fed distributes currency after it’s printing.
However, they go on, “What many questioners might really be asking is whether the Fed has the ability to control how much money is in our economy. That’s a different story. The Fed adds to or subtracts from the amount of money in the economy by buying or selling U.S. Treasury securities and other financial instruments. This is referred to as open market operation since these transactions take place in the open market.” They point out the Fed isn’t allowed to buy securities directly from the U.S. Treasury. “The Fed pays for those securities by crediting funds to the reserves that banks are required to hold, either cash in their vaults, or deposits at a reserve bank. So in that sense,” they go on, “We can think of printing money as adding reserves to the banking system,” said David Wheelock, Vice President and Deputy Director of Research. Then he goes on and says, “These additional reserves enable banks to make more loans, so this process of creating reserves enables banks to make more loans, which expands the money supply.”
What Smart People Are Saying
Is that what everyone believes and knows? The Federal Reserve buys treasuries, step one, that adds reserves to its member banks. Right now there’s 2.2 trillion dollars of reserves, which is a liability of the Federal Reserve and those 2.2 trillion dollars are sitting as assets on banks’ balance sheet. These banks lend out those reserves. That lending of those reserves means there’s more money injected into the economic machine, and that can or will lead to inflation if not hyperinflation.
There are some very, very smart people that echo, reinforce these same points. Here’s Ben Bernanke, and all these quotes come from a post by Cullen Roche of Pragmatic Capitalism, and I’ll definitely link to it in the show notes. Here’s Ben Bernanke, this is in 2009, former Fed Chairman. “But as the economy recovers banks should find more opportunities to lend out their reserves.”
Here’s Nobel Prize winner Eugene Fama, “The Fed knows that if there is an opportunity cost from these massive reserves they’ve injected into the system, we’re going to have a hyperinflation.”
Laurence Kotlikoff, a Boston University Economics Professor, “The Fed is paying the banks interest not to lend out the money but to hold it within the Fed in what are called excess reserves.” Alex Blinder, Princeton University Economics Professor, maybe it’s Blinder, I should know that, he’s pretty famous. In 2009 he said, “In normal times banks don’t want excess reserves, which yield them no profit, so they quickly lend out any idle funds they receive.”
Art Laffer, former Reagan Economic Advisor, “Given sufficient time banks will make enough new loans until they are once again reserve constrained. The expansion of money given an increase in the monetary base is inevitable and will ultimately result in higher inflation and interest rates.”
Finally Paul Krugman, Nobel Prize winner, Princeton University Economics Professor, columnist. In 2012 he wrote, “First of all, any individual bank does in fact have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air.”
How Banks Create Money
Is that what everyone believes? They’re pretty smart, smarter than me. I’ve not said that, have I? I’ve said something similar to what Governor Jon Nicolaisen of the Norwegian Central Bank said in that same speech when he quoted that money is trust. Here’s his quote: “So, how do banks create money? The answer to that question comes as quite a surprise to most people. When you borrow money from a bank, the bank credits your bank account. The deposit, the money is created by the bank at the moment it issues the loan. The bank does not transfer the money from someone else’s bank account, or from a vault full of money, the money lent to you by the bank has been created by the bank itself out of nothing.” Fiat, let it become.”
“The money created by the bank does not disappear when it leaves your account. If you use it to make a payment it is just transferred to the recipient’s account. The money is only removed from circulation when someone uses their deposits to repay a bank, that’s when we make a loan payment. The money supply is therefore only reduced when banks claims on the rest of the economy decreases.” To sum up he says, “Banks create money out of nothing and withdraw it when loans are repaid. Growth in total bank credit is normally matched by growth in the money supply.”
Now maybe he’s just some rogue central banker in Norway. Here’s the European Central Bank: “Commercial banks can also create so-called inside money, i.e. bank deposits, this happens every time they issue a new loan. Banks create money when they issue a new loan.”
Here’s the Bundesbank, the German central bank, “Banks can create book money just by making an accounting entry. According to the Bundesbank’s economist this refutes a popular misconception that banks act simply as intermediaries at the time of lending, i.e. that banks can only grant credit using funds placed with them previously as deposits by other customers. By the same token, excess central bank reserves are not a necessary precondition for a bank to grant credit and thus create money.”
Banks don’t need reserves to make a loan. They create it. It’s an accounting entry. So, why are all these economists saying that’s not how it works? While central bankers are saying that is. Banks can create money. Loans create deposits. It can’t be, it’s got to be one or the other, doesn’t it? Well here this solves it a little bit. This is the Bundesbank again. They write, “Despite its ability to create money a bank still has to fund the loans it has created since it needs central bank reserves for the cashless settlement of payments when sight deposits created by lending are transferred to other banks.”
How Bank Reserves Factor Into To Lending Decisions
What are they saying? Well yes, they can create money out of thin air. They issue the loan. They create a deposit. That is a liability. On the asset side of their balance sheet they have a loan receivable. But, what if the individual taking out the loan decides to go spend the money? The money leaves the bank, and then it gets put in another bank, and so the bank that made the loan has to have sufficient reserves to cover the money that’s coming out because of the loan.
Bundesbank continues, “If a bank lacks the reserves needed to settle the payment it can under certain conditions wait until the deposits have been moved, and the resulting need for reserves become clear, and only then procure the reserves it requires.” These funds can be borrowed either in an interbank market, Fed funds market in the case of the U.S., so from other banks, or directly from the central bank.
Finally the Bundesbank writes, “A bank will try to estimate the volume of reserves it will need to cover its customers’ payment transactions, and bear that projection in mind in its business decisions in matters of lending and funding.”
Banks in the U.S. only have to keep roughly zero to 10% of their deposits in reserves. That’s all. Everything else would be excess, but at the end of the day they’re not making decisions to lend based on how many reserves they have. They have to factor it in. It is a factor in case the money comes out after making the loan, but other deposits are coming in. You have all this money going in and out. They decide on how much they want to lend and money to create based on the demand from households and businesses. What do people want to borrow? That’s a key indication. Then, they decide if your credit worthy. They make the loan. They create it, money out of thin air, and only then do they look to see if they have sufficient reserves, or to make sure they have sufficient reserves to cover their deposits and to potentially fund the loan.
So if you go back to our five steps the Federal Reserve does buy treasuries, and that adds reserves to banks, 2.2 trillion dollars as we mentioned. Step three, banks create money deposits when they make loans. Based on demand they need sufficient reserves to meet minimum requirements and to cover outflows when deposits leave the bank. And that act does increase the money supply, and leads potentially to inflation if there is so much money created, and the capacity of the private sector to produce goods and services is constrained. The vast majority of the money in the U.S. is created in this way by banks in coordination with the central bank.
How The Money Supply Increased
So now we need to look at what has actually happened in practice. Has the Fed injected more money into the economic machine? Has the money supply increased dramatically because of quantitative easing?
Central banks measure the amount of money in the system using what are known as monetary aggregates. In the U.S., there’s two. There’s M1 and M2. M1 consists of currencies, so paper, bills, and notes, and traveler’s checks, and demand deposits at commercial banks, which is just checking accounts. So essentially checking accounts, currency, and traveler’s checks, that’s M1 and that excludes money held by the U.S. Treasury, Federal Reserve Banks, and in the vault at depository institutions, so banks. This is money outside of those organizations out in the private sector. Currency, traveler’s checks, and checking accounts.
M2 is everything in M1 plus savings deposits. So your savings account, time deposits which would be CDs, or certificates of deposits, and balances in retail money market mutual funds, so essentially these are cash equivalents. Things that are actual cash or pretty close to cash. They have a stable value.
What have the aggregates been? M1 in March 9, 2009 so at the depth of the recession right before we had a turn, it was 1.6 trillion dollars in M1. As of April 30, 2018 there’s 3.7 trillion dollars. So it looks like a hockey stick. About 130% increase in M1.
What about loans or debt outstanding? Total private sector debt, non-financial, so excluding banks, so households and businesses. Q3 2008 was $25 trillion. It fell to $23.5 trillion and now we’re at $29 trillion, so about a four trillion dollar increase. We’ve seen an increase in the money supply both in terms of loans, actual cash holdings, or checking deposits.
And so this idea that, has the Fed created money through its quantitative easing program? They have. Have they injected it into the economic machine? Yes, in one aspect they have, but there’s an important caveat that I’ll get to in a moment. The New York Fed has a blog called Liberty Street Economics, and I’ll link to it in the show notes because they have a chart that I want you to look at.
Here’s what they write, “The chart below shows that M1 growth is highly positively correlated with the growth and reserves generated by Fed’s asset purchases. The reason for this is simple. Reserves held with the central bank are assets for the bank.” We talked about that. That’s an asset, that reserve. It’s created out of thin air by the Federal Reserve.
“As the Fed expands reserves,” they go on, “banks must either sell other assets keeping the overall level of assets unchanged, or issue more liabilities, or equity expanding the level of assets or some combination of the two.” So they have these new reserves. They now have new assets that need to be matched by a liability or equity so the bank’s accounting books balance. Now if the bank already has treasury bonds on its balance sheet as an asset as part of QE it would just essentially swap that treasury bond for new reserves, and then the bank’s asset balance would stay the same. But we’ve seen that the money supply has actually increased, the money supply in terms of checking deposits.
Liberty Street Economics goes on, “In fact banks did not reduce their overall holdings of other assets as reserves increased. Instead banks mainly funded these new assets by issuing additional liabilities including deposits. Over the same period interest rates were low, reducing the incentive for households to place their funds in interest-earning savings accounts rather than checking accounts. Correspondingly, much of this increase in bank liabilities has been in the form of checkable deposits. This explains why M1 growth has grown more than M2.” So M1 again doesn’t include savings accounts. But what they’re saying is that banks assets actually, their balance sheets ballooned. As they’ve gotten more reserves, the liability side of their balance sheet has also grown in the form of more checking deposits. Does that mean there’s way, way more money? Yes, but it depends on how you define money. If we define money as checking accounts, yeah, that’s how it worked.
More Liquidity, Not More Wealth
But here’s the thing. How did those deposits get there? Think about the central bank. If they went out and bought a treasury bond from a household and exchanged it for cash, bills you know, dollars, that’s another transaction. The Fed has the money. They create it, and they just exchange it. They exchange it with a household. Now the Fed has the treasury bonds. The household has the cash, and then they take that cash and they deposit it in the bank. That’s what happened. The balance sheet expanded. That’s all that happened.
Is that household more wealthy? No. They had an asset, a treasury bond, and they swapped it for either cash but effectively for a bank deposit. It’s like my account, right? At Schwab. Let’s say I have a treasury bond. I sell it. I get the cash and I move it to my bank to my checking account. So what happened is effectively there was new money created in the sense of more money supply because households and businesses became more liquid. There was less treasury bonds held by the private sector because the Federal Reserve bought those, and now the private sector has more cash primarily in the form of bank deposits, so they’re not any wealthier. They’re just more liquid.
When you sell an asset and now have cash do you feel more wealthy, and are you more likely to spend? And, will that create inflation if everybody decides to spend their assets? We could create inflation that way because we could constrain the capacity of the private sector to produce. If everybody wants to buy products and services, liquidate their savings, that definitely could spark inflation. But they haven’t, which is why M1 has actually increased so significantly as part of the quantitative easing program because the treasury bonds, the assets were sold, the proceeds were moved to cash, and are primarily held in checking accounts, and to some extent savings accounts on the balance sheets of banks.
In summary, does the Federal Reserve print money? They do create money when they buy treasury bills because those reserves, again, that’s also an accounting entry. They just credit the reserves on banks. That’s a liability to the Federal Reserve. It’s an asset of its member banks. It’s an accounting entry, so the money is created out of thin air. Those reserves are now assets of the banks. They can create money, commercial banks when they make a loan. That’s also an accounting entry. They don’t look to the reserves to decide whether they’re going to make a loan or not, they look at the demand for loans. They look at their business plan as a bank. But they do refer to their reserves because once they create the money, make the loan, those loans have to clear, and so they will make sure they have enough reserves. They don’t have to access those reserves to make the loan. They can always borrow the reserves if they’ve come up short, so that’s not a factor.
And so, we’re sort of somewhere in between. Everyone’s a little bit right, and everyone’s a little bit unclear, and at the end of the day we’ve not had hyperinflation, or not much inflation at all. Why? Because the private sector hasn’t been willing to borrow enough, so there hasn’t been enough money created to strain capacity of the private sector to produce goods and services. There’s not been that constraint which has pushed up prices. It just hasn’t happened nor has the private sector, households and businesses, been willing to spend the money to create the demand that again could constrain the private sector. It could happen. It’s something we’re monitoring. But it hasn’t happened yet, and it isn’t because the Federal Reserve has printed money.
That’s Episode 205.