This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.
The Princeton professor and former Governor of the Federal Reserve Alan S. Blinder (here) isn’t concerned about the recent explosion of the money supply because “the Fed knows how to shrink the mountain of bank reserves by selling assets rather than buying them.”
This essay shows why it will be impossible for the Fed to significantly reduce the money supply and why the Fed is playing with fire.
The Board of Governors of the Federal Reserve made two regulatory changes that eliminated the Fed’s ability to reduce the money supply. On Mach 26, 2020, the Board reduced banks’ reserve requirements to zero. This means that a sale of securities of $100 now removes checkable deposits of $100. If reserve requirements were higher and binding, say 10%, a $100 security sale would reduce checkable deposits by $1,000.
The second change occurred on April 24, 2020, when the Board eliminated restrictions on the transfer of funds between checkable deposits and savings accounts, which already had a zero reserve requirement. With this change, checkable deposits and saving deposits became perfect substitutes. Funds can be quickly moved from one account to the other without incurring any cost (the Board’s firewall separating these accounts has been porous for some time, but this change made it official). With this change, checkable deposits, which were $3.7 trillion in April 2020, effectively increased to $14.3 trillion in May 2020. In February 2021 these deposits were $16.3 trillion. The remaining component of the M1 money measure, currency, was $2 trillion.
Checkable deposits are the largest component of the M1 money measure and the only component of any measure of money that the Fed can directly affect. Consequently, in order to reduce the money supply significantly, the Fed would have to remove much of the $16.3 trillion of these highly liquid deposits. The Fed is currently holding $7.1 trillion in securities, $4.6 trillion in longer-term Treasuries and $2.2 trillion in mortgage-backed securities.
The most the Fed can reduce the money supply is $7.1 trillion.
It is important to understand what happens when the Fed sells securities. To see what happens, suppose the Fed sells $1,000 of securities to someone. Whoever purchased these securities pays for them by writing a $1,000 check against a bank. The Fed goes to the bank to “cash” the check. Banks currently hold about $3.1 trillion in deposits with Federal Reserve Banks, so initially the bank would pay the Fed by simply having the Fed reduce its Fed deposit by $1,000.
Deposits with the Fed are critical for banks’ daily operations and for the smooth functioning of the payment system generally. Reducing these deposits to zero would be a disaster for an individual bank and for the banking system and the economy. Hence, once these deposits are reduced to a level that was interfering with the bank’s daily operations, the bank would pay the Fed by borrowing $1,000 from the Fed at the “discount window.”
The Fed would make the loan to the bank, knowing that if it didn’t the bank would have a serious problem.
The Fed could reduce the money supply, by say $7 trillion, by reducing checkable deposits by $7 trillion. But in so doing, it would effectively replace its holdings of securities with long-term loans to banks. Since banks have $3.1 trillion in Fed deposits, the balance sheet would likely shrink to about $4 trillion. The $3.1 trillion in deposits would no longer be necessary or useful because the $4 trillion would be sufficient for banks daily operations and the smooth functioning of the payment system.
Conclusion: it will be impossible for the Fed to significantly reduce the money supply should inflation begin to accelerate unexpectedly, which is of course what has always happened historically.
A disastrous outcome could occur if the Fed’s large security sales caused investors to sell long-term securities.
Massive sales of long-term securities by domestic and foreign investors would likely cause long-term bond prices to fall, reducing the market value of the Fed’s holdings of long-term securities. Interest rates on longer-term Treasuries have increased significantly since July 2020. Consequently, the market value of marketable Treasury debt has already declined 8.8% since then. If long-term rates remain high or rise further, the Fed would incur capital losses when they sell.
This is not a good thing for an organization that has only $39 billion of capital.
Being forced to sell securities at a loss alone could damage the Fed’s credibility.
The Fed’s decision to massively expand its holdings of long-term securities is tantamount to playing with fire.
Long-term rates could increase rapidly and by a large amount either because of a sharp and sudden increase in the inflation rate or an increase in inflation expectations. This could also happen if investors smell blood and make massive sales of long-term securities in an attempt to damage the Fed.
Either way, the Fed could be in a fight for its own survival.
It was a huge mistake for the Bernanke Fed to takes on a large amount of interest rate risk, for the Yellen Fed to maintain it and for the Powell Fed to take on even more. It is an especially big mistake since there is no significant evidence that purchasing large amounts of long-term debt reduced long-term interest rates, stimulated spending, reduced the unemployment rate or produced faster economic growth (see my previous essay, here).
Of course, the Fed could obtain more leverage over the money supply by reinstating reserve requirements and by putting an effective firewall between checkable deposits and savings deposits. But it would look very foolish.
People would rightly wonder if the Fed knows what it is doing. I wonder about this all the time.
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.