The Federal Reserve’s monetary policy has stabilized the US financial system, but its power to help the economy recover more swiftly is more limited than many people may be willing to accept.
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—Jeremiah Harman, director of the Bank of England, statement before the Bank Charter Committee on the bank’s policy during the Panic of 1825.1
In the past 12 years, the US Federal Reserve (the “Fed”) has faced two major financial crises. One started within financial markets (the housing finance collapse of 2007–2009) and one involved an outside shock (the COVID-19 pandemic). The Fed responded in each case with an alphabet soup of new programs, and despite the differences between the two crises, these actions had a similar effect: stabilizing the financial system. But in both cases, the Fed’s impact on employment and economic growth has seemed sluggish at best.
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If the Fed can shore up a tottering financial system through monetary policy, why hasn’t it been able to help the economy recover more swiftly? The candid answer is that the Fed’s power is more limited than many people may be willing to accept. In both the 2007–2009 and the 2020 crises, the Fed pulled many levers in its effort to avert total financial system collapse, but these levers focused on keeping the financial system operating. That’s a necessary—but not sufficient—requirement for a healthy economy. If businesses continue to see excess capacity, and if consumers are worried about the future and unwilling to spend, the economy will suffer—and there is little the Fed can do. Especially today, when interest rates are already at near-zero levels, the Fed just doesn’t have the tools to put the economy back on track. To speed the recovery, the onus should be on Congress and the president—not the Fed—to consider how best to get the economy moving again.
Why does the Fed exist?
To understand why the Fed’s leaders took the actions that they did in 2020—and why those actions are having an important, but limited, impact—it helps to know something about the Fed’s purpose.
The financial system appears at first glance to be very technical. But it’s not really that complicated. The financial system—banks, stock markets, financial planners, traders, hedge funds—exists to match savers (mostly households) with people and organizations (investors)2 who wish to turn those savings into capital assets—buildings, machines, even ideas—that produce goods and services. The players in the system—“financial intermediaries” in the jargon of finance—offer a wide variety of “products” designed to balance the needs and desires of the savers with those of these savings’ users (the aforementioned investors). These investors are mainly businesses that wish to increase their capacity to produce goods and services by purchasing capital goods such as buildings and machines. Financial products that help to connect savers and investors range from savings accounts at banks to exotic derivatives.
Many financial products are traded in markets, which allows savers to buy and sell ownership of those assets as they see fit. If there is regular trading in a market, financial experts say that it is “liquid.” Savers like assets that are traded in liquid markets because they can sell them any time they wish. Investors like liquid markets because they can plan on being able to borrow when they need cash for operations or even just to make payrolls. But what happens when trading stops in a liquid market?
That’s not an academic question. It is precisely what happened on a regular basis starting in the early 19th century as the number of financial products multiplied. These financial “panics” occurred when people suddenly decided that they didn’t want to hold a particular asset, and trading in that asset suddenly stopped. Suddenly, financial intermediaries could no longer match savers and investors. The result: The economy’s ability to support investment—houses, commercial buildings, industrial machinery, computers—plunged because those wishing to acquire capital goods found it impossible to find financing. When this happens, the economy goes into a tailspin. The same pattern has held from before the British Railway Mania of the 1840s through the global financial crisis of 2008–2009.
One of the Fed’s key responsibilities is to prevent such panics, or at least to prevent them from having a large impact on the real economy of production and employment. The simplest way to do this is to provide money—liquid assets—so that savers and financial intermediaries can meet their obligations. But in addition, the Fed and other central banks can step in to keep markets functioning. That’s what the Bank of England did in the early 19th century—and that’s what the Fed has been doing in 2020. The quote at the beginning of this article comes from a parliamentary investigation of the Panic of 1825, and describes the Fed’s actions this year remarkably well.3
The pandemic panic
US financial markets started to react to the spread of COVID-19 in early March. The pandemic created a huge amount of uncertainty, impelling traders to become unwilling to trade anything that might be at risk from the pandemic. This led to a sell-off in markets that were perceived as being risky and a strong desire to hold the safest assets possible—US Treasuries. Without asset buyers, some markets looked like they might shut down completely.
This was evident in the returns being offered to savers to entice them to purchase those assets. Figure 1 shows the spread, or percentage point difference, between the return paid in four key financial markets compared to the return on a “safe” asset (a Treasury security of similar duration). The average spreads in 2019 are a good measure of “normal” spreads that account for the (sometimes slight) differences in the overall riskiness of these assets. For example, commercial paper is a close substitute for Treasury bills, and almost as safe. Under normal conditions, the spread between them is very small. But in March 2020, the interest rate for commercial paper suddenly soared above the rate for Treasury bills, for a spread of almost 2%. This reflected a sudden preference for Treasury bills by savers seeking safe short-term places to park their money. For businesses that depended on commercial paper markets to obtain cash, the higher interest rate was a sudden and unexpected cost. Worse, there was the possibility that savers, thinking that private debt would be too risky, would simply shun the commercial paper market at any interest rate. If that were to happen, it would leave businesses that planned to raise money via the commercial paper market short of cash, and perhaps unable to pay bills or salaries that depended on that cash.
Something similar happened in other markets. For instance, short-term money markets suddenly became suspect relative to the safety and liquidity of short-term Treasuries. Corporate AAA bonds also suddenly looked risky, and the markets forced up the yield relative to equivalent long-term Treasuries. And many savers did not want to take on the additional risk of holding mortgages in an economy with high unemployment, so the mortgage rate spiked relative to Treasuries. Because of these developments, corporations using the bond market to fund investments and homebuyers wanting to purchase a house might have found the market dried up and their plans interrupted.
That’s why the Fed stepped in. First, it did something very traditional: It supplied a lot of liquidity in the form of cash so banks could intervene if necessary. But that wasn’t really enough. So the Fed then became a direct buyer in a variety of financial markets to be sure that those markets could continue to operate. This prevented businesses and households that had planned to use those markets from having their access to cash interrupted.
Each market required a separate program, so Fed watchers were inundated with alphabet soup: the MMLF (money market liquidity facility), CPFF (commercial paper liquidity facility), MSLP (main street lending program, to buy loans extended to smaller businesses), MLF (municipal liquidity facility, to buy short-term state and local debt). Each program has distinct requirements and limits tailored to the market the Fed wishes to support.4 Some require more Fed action than others. But all share the goal of keeping open a particular channel for connecting savers and investors.
Supplying liquidity, and then buying all those assets, have ballooned the Fed’s balance sheet. Figure 2 shows the total assets held by the Fed from 2005 to 2019.
Until the 2007–09 global financial crisis, the Fed held only Treasuries.5 A key part of the Fed’s response to the global financial crisis after 2009 involved purchasing longer-term Treasuries and mortgage-backed securities (MBS). That move was the famous “quantitative easing,” which generated a lot of debate in the mid-2010s. You can see the rise in assets owned by the Fed around that time.
In 2018, the Fed started to take steps to reduce its holdings of MBS and longer-term Treasuries, first by not replacing maturing MBS, and then by actively selling the remaining holdings at a slow, steady pace. That was interrupted by the pandemic, however, and the Fed is now buying (and sometimes selling) a surprising variety of assets. At the end of July 2020, the Fed held US$2.6 trillion in non-Treasury assets, about 37% of its balance sheet. And financial markets continued to operate normally. The Fed’s actions successfully prevented the pandemic from causing a financial crisis—no small feat.
What? No inflation?
As any accountant knows, a balance sheet balances—which means that the Fed’s liabilities grew with its assets. The liabilities of a central bank are mostly currency and commercial banks’ reserve deposits. Banks are required to hold reserves, with the amount depending on the size of the bank deposits (such as checking accounts) they have outstanding. Because bank deposits are the main form of money in a modern economy, the Fed’s creations of reserves should—under normal circumstances—determine the size and growth of the money stock.
Sure enough, as figure 3 shows, March 2020 saw a sudden acceleration in bank reserves in the two most common measures of the money stock: M1 (currency and checking accounts) and M2 (M1 plus some savings and time deposits). With M2, the broadest measure of money, growing at over 20% in the past year, can inflation be far behind?
That conclusion is a severe oversimplification of basic monetary theory. According to the theory, inflation is described by an equation that many readers will remember having learned in an economics class:
MV = PT
M is the supply of money, V the velocity at which money circulates (i.e., the number of times in a given period money is used, on average), and PT the value (price times number) of total transactions in a given time. If the velocity and the number of transactions don’t change much, a large increase in M, the supply of money, should create a large increase in P, the price level. And if the money supply grows quickly, the price level will follow—meaning the economy will experience inflation.
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As is often the case in economics, however, it’s the assumptions that matter. The velocity of money is not constant: It depends on how much money people want to hold at any given time. And financial crises create conditions that make people want to hold a lot more money in their portfolios. This means that velocity, V in the above equation, has fallen considerably during the pandemic. The velocity of M1, for example, fell from 5.5 in February to 3.9 in March6—reflecting savers’ rush to safer assets and the consequent huge demand for liquidity that threatened to freeze many financial markets.
Because the velocity of money decreased so sharply (and remains low), the Fed’s asset purchases are very unlikely to create inflation even though the money supply has swelled. In fact, the Fed did the same thing in 2008, and predictions of future hyperinflation at the time proved to be unfounded.7 The median forecast for inflation in 2021 is around 2.0%, which means that inflation is rightly very low on the Fed’s list of concerns. (See “Appendix: Who’s afraid of the big, bad money supply?,” for an explanation of the historical context of the argument that money creation will lead to inflation.)