Central banks are hard to understand, and the opaque terminology used to describe their activities makes things even worse. So when a Federal Reserve policy-making meeting is described in news article with headlines like “Fed Says Balance-Sheet Unwind to Start Soon,” as happened Tuesday, only a fraction of the population understands what it means.
Having taught economics for 45 years, I know that getting people to understand central banking is a tough nut to crack. But let’s see what we can do in two columns.
A central bank exists to furnish a society with money that can serve as a way to buy and sell things, to store value from one point in time to another and as a common yardstick for measuring value. The Federal Reserve is the central bank of our nation.
A modern economy needs a money system that can fluctuate to meet the needs of the economy. Congress recognized that in 1913 when it specified that the purpose of the new Fed was to “provide an elastic currency.” That is what the Fed does. It expands and contracts the amount of money circulating. While one may be assigned other functions such as auditing banks, or clearing checks, managing the amount of money in the economy is the reason for existence of a central bank.
The amount of money is not readily perceptible by the average citizen. Interest rates are and Fed actions thus are presented in terms of raising or lowering rates. But this is only an indicator of what is being done to the amount of money just as a speedometer needle is only an indicator of the amount of fuel fed to an engine.
“Money” historically consisted of currency — paper bills and coins — in circulation plus bank deposits. Now various forms of electronic money such as stored value cards complicate the definition, but most electronic forms of payment still tie back to some bank account.
Banks are financial intermediaries.They accept deposits from some and lend to others. Since they are handling other people’s money, they may not lend out all the money deposited. By law, a fraction must be held as “reserves.” Banks may keep more such reserves than the legal minimum. These funds are kept at the district Federal Reserve Banks, such as that in Minneapolis. These accounts are used on a daily basis in the clearing of checks and of electronic transfers. Any excess above the minimum can potentially be lent out. Such reserves are key in the expansion and contraction of the money supply.
Historically, there were three ways in which the Fed could alter the money supply. The first was to change the “reserve ratio” or fraction of total deposits that must be held in reserve. The lower this reserve, the more banks can lend out and the more money effectively circulating in the economy.
However, that ratio is now near zero and changes in the ratio have large effects on the money supply. So this tool is hardly ever used by the Fed but may be in other nations.
The second way is for the Fed to make loans directly to commercial banks that lend to the public. This is why the Fed was instituted. Banks could have customers with excellent credit and collateral who needed loans, say for planting crops or stocking retail stores. But a bank might have loaned out all the deposits allowed. If not for the Fed, it would be stuck. But the new district banks could make loans directly to banks, depositing the money directly in their reserve accounts. This could be loaned out, thus increasing the amount of money in circulation.
The banks had to present collateral such as promissory notes for loans already made. This was valued at less than the face amount. It was “discounted,” and thus the interest rate that the Fed charged the borrowing retail bank was the “discount rate.” By lowering this discount rate, the Fed could increase the amount it lent and by raising it, reduce such loans.
It thus increased and decreased the availability of money in the overall economy. And, for any given demand for money, a larger supply lowered overall interest rates, following the Fed’s action, and a smaller supply raised rates. If done judiciously, fluctuations in the economy could be accommodated and yet the general price level kept stable. However, if the money supply was increased too much, inflation would result. If shrunk excessively, deflation would result and the economy would fall into recession. This had been common in the 50 years leading up to the Federal Reserve Act of 1913.
The key factor not yet mentioned is that the money loaned to banks was created out of thin air by the Fed. It did not come from the U.S. Treasury or the selling of bonds or anywhere else involving money already circulating. The Fed would just make a pen and ink increase in the balance in the borrowing bank’s reserve account. Now it is a computer keystroke. This ability to “create” new money is unique to a central bank and is its reason for existence. But it confounds people hearing it for the first time.
Another important point that gets less mention is the fact that when a bank paid off such a loan, the repaid money did not “go” anywhere. The Fed just destroyed it as simply as it had created the money in making the loan.
Any entity must account for its funds, and the Fed is no exception. But the fact that it can create and destroy money makes its situation unique. Loans to banks were assets, things of value that the district bank owned. There had to be offsetting liabilities. These largely were the reserves held for banks. The Fed was the custodian of such funds, but the ownership remained with the commercial banks. And then there were Federal Reserve Notes, the paper currency in our pocketbooks.
This is where people get confused. When someone owes you value, you can demand that it be paid to you in kind or in money. If you have a dollar bill in your wallet, the Fed owes you that value. But if you take it to the Fed and demand the value owed you, all they can do is give you another identical piece of paper.
The third tool to vary the money supply is the Fed buying and selling bonds issued by other entities, usually the U.S. Treasury. When there is a budget deficit, the Treasury must borrow by “selling” bonds. These are promissory notes that really differ little from the farmers’ and merchants’ promissory notes presented as collateral to the Fed in its direct lending to banks.
Changing the money supply by the Fed increasing or decreasing direct loans to banks depends on decisions by the banks to borrow more or less. But the Fed can put more money into the economy at any time by simply going to open markets, where bonds are bought and sold every day, and buying bonds. In the market they are no different than a mutual fund or insurance company or trust fund or college endowment.
However, when the Fed pays for the bond, it doesn’t need to have existing money somewhere as these other entities do. As with making loans to banks, the Fed can simply create new money that goes into the reserve account of whichever commercial bank has the bond’s seller as a depositor. In effect, the Fed writes a check on itself, and when the check is presented to it for payment by the bank in which it was deposited, a keystroke settles the obligation. Money goes into one bank’s reserve account that does not come from anywhere else. It is created out of thin air.
Again however, when the Fed sells a bond and gets paid for it, the money is destroyed. It came from the buyer of the bond but does not go to anyone else in the economy.
That is a lot of detail and we are still a couple of steps away from explaining what it means for the Fed to “reduce its balance sheet,” or expand it, for that matter. But that will have to wait for a second column.