The Federal Reserve Money Machine

Every day, people around the world trade their time, effort, and energy to earn money. But what is money? Money is an item that acts as a unit of account, medium of exchange, and store of value by which exchanges are made more efficient. Prior to money, humans exchanged goods and services through bartering, an incredibly inefficient system. Bartering would be suitable in an economy with only two goods, but the real world is far more complex than that. Money acts as a mutually accepted “good” that allows the transaction costs and inefficiencies associated with bartering to be eliminated. 

While it is debated what exactly the first “money” was, it is agreed that money started as “commodity money.” Initially, commodity money consisted of livestock or grains. As time progressed, precious metals began to develop to replace the prior food-based currencies. This change happened for a few reasons: metals weren’t subject to droughts, they were scarce, and they had intrinsic value. While precious metals have always been in demand, they have one major downside as money: they’re cumbersome to carry around. To combat this, banks began to issue bank notes that were “backed” by some precious resource to legitimize the value of the notes. If a bank note was backed by gold, then this backing would be called a “gold standard.” 

Under a gold standard, money is near inflation proof. The limited supply of gold in the world limits the issue of bank notes. In this system, money issued acts as a claim on a certain amount of gold. As such, the value of the money remains stable, as issuing more notes without adequate gold would erode trust in the currency. The amount of gold provides a natural limit to the amount of money in circulation. 

The modern monetary system does not have this natural limit. In the United States, the dollar was taken off of the gold standard in 1933 and the convertibility of the U.S. dollar into gold ended in 1971. At this point, the dollar became a fiat currency, in which the value of the currency is backed by government guarantees. Since 1971, inflation has occurred because of  continuous increases in the monetary base, which consists of currency and bank reserves held at a central bank. 

In any case, the money that we use does not come out of thin air, it instead comes from the Federal Reserve (the “Fed”). The Fed creates money by purchasing an asset (usually Treasury securities) through open market operations. The Fed does this by working with primary dealers in the secondary market, buying or selling government securities in order to influence the money supply and interest rates. The Fed impacts interest rates because, as it buys and sells more securities, interest rates change. Purchasing securities injects money into the system, while selling pulls money out, affecting the money supply overall. 

In recent years, the Fed has taken actions that warrant concern, namely quantitative easing (“QE”) and the Fed’s shaping of interest rates. Quantitative easing is an expansionary monetary policy in which the Fed purchases assets on a large scale to inject liquidity into the financial system, which increases the money supply. This affects the Federal Funds Rate (“FFR”), the interest rate that the Fed can directly control, by lowering it. This relationship exists because, as QE increases the money supply, downward pressure is put on interest rates (including the FFR). Since interest rates and quantity of money have an inverse relationship, when QE increases the money supply, the FFR goes down. This, in turn, encourages borrowing and longer-term investment. Lower interest rates reduce the cost of borrowing, which makes loans for projects, large purchases, or investments more attractive. QE also lowers the yields on long-term Treasury securities, flattening the yield curve and pushing investors and firms to seek higher returns through riskier investments.  

QE allowed the Federal Reserve to inject trillions of dollars into the system, which has led to broad-based price increases. For example, in June 2008 (five months before the first round of QE), the Fed’s adjusted total assets totaled $896 billion. In June of 2022 (two months after the fourth round of QE), that number was $8.915 trillion. In 14 years, the Fed’s balance sheet increased by almost a multiple of ten. This money came primarily from QE.

Meanwhile, starting in October 2008, the Federal Reserve began to pay interest on reserves, which incentivized banks to hold excess reserves. This policy was enacted to prevent excess money from being released into the banking system through lending. But in March 2020, reserve requirements were removed. Prior to that, banks were required to keep a certain amount of reserves at the Fed, primarily as a safeguard against bank runs and other liquidity crises. Today, banks are free to choose the level of reserves they hold. While they earn risk-free income on all reserves held at the Fed, banks are still subject to other liquidity regulations. Formal reserve requirements, however, no longer exist.

Looking at Consumer Price Index (“CPI”) data, the FFR, and the Federal Reserve’s balance sheet, traditional erosion of the buying power of the U.S. dollar was not observed on a tremendous scale until the COVID-19 response. This initially appears impossible: more money was being created rapidly, but there was not a correlated increase in CPI inflation. Although CPI inflation was muted for years—only increasing by 0.377 on average from June 2009 to February 2020— there was still a different kind of inflation: asset price inflation. 

Primary dealers greatly benefit from interest on reserves, as they typically hold large amounts of reserves at the Fed. Holding more reserves at the Fed provides a low-risk, steady source of income. This risk-free income added stability to the system while also guaranteeing a profit for primary dealers. Yet, this easy profit discouraged productive investments, as interest could be earned simply by holding reserves without lending. 

These policies also contributed to asset inflation by distorting incentives. When inflation increases, people put their money into assets like securities, real estate, or commodities. This relocation of money bumped up the demand for these goods, which pushed asset prices even higher. Primary dealers and large financial institutions benefited from this environment, using cheap borrowing to make larger bets in financial markets. 

Meanwhile, the average person did not share that advantage. They were hit with increasing prices and no way to take advantage of all the gains that were being realized. The wealthiest 1%, on the other hand, benefited greatly. They already had the money and credit to borrow at low interest rates and invest more. 

Getting money right is vital in any economy, and the Federal Reserve has greatly devalued the U.S. dollar, increased the gap between the top 1% and everyone else, and dumped so much money into the system that the “old way” of doing things is unlikely to come back. To quote Christopher Leonard’s book The Lords of Easy Money, “the long crash of 2008 had evolved into the long crash of 2020. The bills had yet to be paid.”