The Fed is pushing the pedals of the economy – Twin Cities

The Fed’s Open Market Committee met last week and announced its two-part decision.

Edward Lotterman

First, its target “federal funds” interest rate is up half a percentage point, from a range of 0.25% to 0.5%. It is now 0.75 to 1%: “The Fed has raised interest rates.

Second, it will “reduce the size of its balance sheet”. What does it mean? In short, it will reduce the money supply circulating in the economy.

But, as I explained last week, the two are not disconnected. Changes in the money supply are the key variable. These manifest themselves, in several ways, in changes in the assets and liabilities of the Fed. Interest rates are only a result, an indicator.

A law co-authored by the late Minnesota Senator Hubert Humphrey states that the Fed must achieve maximum employment and low inflation. An inherent contradiction is like saying that true friendships require absolute honesty and never giving offense.

The Fed manages the overall availability of money by increasing and decreasing the amounts of reserves held by private sector banks, the ones in which most of us have accounts. To use last week’s metaphor, the money supply is to the economy like the amount of gasoline injected is to the engine of a car. Interest rates are the visibly changing speedometer.

The link is neither exact nor immediate, although “stepping on the accelerator” is a common phrase attached to Fed actions. The relationship between pressing the accelerator pedal and your car’s speed depends on whether you’re going uphill or downhill, towing a trailer or not, with strong winds behind or ahead.

And there are lags. A friend’s tractor backhoe has an automatic transmission with lots of slippage, so one can fill the bucket without shifting gears or choking the engine. But to get moving, you have to press the accelerator pedal and wait a few seconds. Releasing the pedal does not slow it down quickly.

And there may be some technology where trying to add fuel doesn’t change the speed. Driving a friend’s rental truck all the way to Oregon, I planned to drive at highway speeds. But once on I-94 west, cruise control limited the truck to 65 mph no matter how far I pressed the pedal. It’s a great metaphor for the “quantitative easing” of the past decade. The Fed could only push so hard.

What does all this have to do with the “balance sheet” of the Fed?

Go back to 1914. That’s when Congress created the Fed “to provide elastic money” that could expand and contract with the needs of the economy.

It used to be that a bank, say in Elbow Lake, Minnesota, would take savings and checking deposits. She lent most of it to merchants and farmers. The banking law required him to keep some in reserve. He could keep more if he wanted. Everything may be “loaned out”, but with solid customers who still need loans.

With the Fed’s new system, the same bank could take promissory notes of loans already made at the Minneapolis Fed’s “discount window” and say, “We need more money to lend.” Can we borrow some? These IOUs will be a guarantee. If we do not repay this loan from you, the Fed may collect principal and interest owed by store owners and farmers on them.

The Fed would say, “Yeah, we’re going to put the money in your reserve account here. Dip into these “excess reserves” in Federal Reserve Notes or by presenting checks for payment. Thus, the bank of Elbow Lake could grant more loans to customers. The money supply had increased.

The crucial magic here is that this new money available to the small town bank doesn’t come from nowhere else. It was completely new. If a small town bank had borrowed from a large commercial bank in Minneapolis or Chicago, the money held by that large bank had to decrease in order for the money in the Elbow Lake bank to increase. But the new Fed district bank could just wave a magic wand, say “shazam,” and there was fresh money.

With the increase in the American money supply in this way, business and commerce could prosper. But if the Fed banks went wild and over-lended, the increase in available money would exceed the increase in goods and services. The new money would nonetheless stimulate spending. Prices would rise – in other words, inflation.

On the other hand, when the local bank later repaid its “discount loan”, the money just went “poof” and disappeared. The national money supply has shrunk. In all of this, the Federal Reserve Act worked as intended.

But there was a problem. Sometimes there was unused productive capacity in the economy. A larger money supply could have helped increase production and employment. But, for some reason, the banks did not go to the Fed for funds to make more loans. You can lead a horse to the water trough, etc.

In the 1920s, before the presently organized Fed existed, Benjamin Strong, President of the New York Fed, discovered that it could also increase the money available simply by buying U.S. Treasuries “on the open market.” free” in competition with insurance companies or private savers. As with loans, the money to buy bonds could simply be created out of thin air. Shazam! However, as with discount loans to banks, when the treasury bill was sold, the money disappeared.

This was the start of “open-market operations” of buying and selling bonds, overseen after 1935 by the “Federal Open-Market Committee”, the same body that met early last week . Beyond buying and selling bonds, he can make short-term promises to buy or sell the so-called “repo” described in my column last week.

The Fed has a balance sheet. Just like you, your 401(k) or your bank, a bond held is an asset. But the Fed’s liabilities are special. These are Federal Reserve Notes, written ornamentally on top of all our paper money, and represent the reserve accounts of commercial banks. The banks own it, the Fed is just a custodian.

So, when the Fed “shrinks its balance sheet”, it has to sell some of its assets, the bonds it owns. The received money disappears. The balance sheet must balance out, and therefore one of the Fed’s liabilities, the reserves, must fall. This means that banks have less money to lend. Interest rates are rising, which shows just how much this is happening. To use the previous metaphor, the Fed is “stepping on the brakes”.

This is how the central bank works. Aside from the initial stock market swings, wait a few weeks and you’ll see how this all applies to 2022.

St. Paul economist and writer Edward Lotterman can be reached at [email protected]

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