My recent article on how the Federal Reserve creates money drew a lot of responses. One follow-up in particular from a FEE Daily reader caught my eye. Samuel asks,
“What happens when the Federal Reserve sells (or otherwise gets rid of) the Treasury bonds that they hold? Is the money then removed from the economy?”
I think the best way to tackle this question is by talking about restrictive monetary policy as a whole and what, if any, impact it will have on our inflation woes.
Bonds for Sale
Samuel is right about his theory of what happens when the Federal Reserve sells bonds. We learned in the previous article that when the Federal Reserve wants to increase the supply of money, it offers to buy bonds that private banks hold. To purchase these bonds, it uses newly printed money which goes into banks. Economists call this an open market purchase.
Banks can lend out this new money leading to an increase in the money supply. So long as banks lend out (or even expect to lend out) any of the money acquired from open market purchases, the money supply grows. This is true even if banks only lend out a small fraction of the new money.
This brings us to Samuel’s question. Can the Federal Reserve do the reverse? In short, yes.
Let’s say the Federal Reserve wants to decrease the amount of money available for lending. What can they do? Well they can offer to sell some of their previously acquired bonds to banks.
When banks buy bonds from the Federal Reserve, they give up some of their loanable funds, which means the supply of money available to be lent out falls.
When this happens, borrowers must compete for a smaller amount of loanable funds, and this competition drives up interest rates. This is one form of what economists call contractionary or tight monetary policy. (Think of interest rates as the “price” in the market for loanable funds. This price is driven by supply and demand just like any other price—in this case, the supply of and demand for loans.)
Why would the Federal Reserve want to do this? Tight monetary policy is mostly utilized to combat rampant inflation.
When the supply of money increases relative to the supply of goods and services, this results in higher prices for goods and services. Given the current state of the economy, I don’t have to spend much time discussing the downsides of high inflation.
So when inflation becomes a concern to the Federal Reserve, they can use contractionary monetary policy to lower the amount of funds available to businesses in order to slow their investment. The hope is that by slowing this investment spending, the lower economic activity that results will mean prices stop rising so quickly.
How is the Fed Trying to Achieve a Soft Landing?
The ideal goal of the economists who work for the Federal Reserve is a “soft landing.” Money-printing was used to increase spending and prevent massive economic crises during the Covid-19 pandemic, and now the experts want to slowly let out the air to prevent rampant inflation.
So is the Federal Reserve utilizing open market sales to lower the money supply? Not really. This isn’t the primary factor driving the contractionary current monetary policy. The Federal Reserve doesn't need to use open market sales to have a contractionary impact for a couple of reasons.
First, much of Federal Reserve policy currently consists of promises to engage in future open market purchases.
Consider an example. Let’s say you go to a car lot to purchase a Tesla. It’s the only car lot for hundreds of miles. Now imagine two scenarios.
In scenario 1, there is only one car available, and once it’s gone there will be no more for the foreseeable future.
In scenario 2, there is only one car available, but you know that a new shipment of cars is coming in tomorrow.
Under what scenario would you be willing to pay more for the car? Scenario 1, of course. This illustrates an important truth. Expectations about the future supply of something can affect the value of that thing today.
Money is no different. If the Federal Reserve promises they will be making huge open market purchases every month with no definite end date, borrowers reasonably consider this future money as a part of the supply today. As such, when the Federal Reserve announces future open market purchases, interest rates won’t wait to change.
The Federal Reserve has announced they will be tapering off their open market purchases a significant amount. This announcement, if the market perceives it as credible, has the same impact as open market sales. The supply of loanable funds is viewed as lower.
The Federal Reserve has let many of their bonds mature without replacing them with buying new bonds. This graph illustrates that plainly.
Figure 1: Treasury Holdings
Holdings of Treasury securities increased significantly from January 2020 until June 2022 but have been falling since.
But recently, open market operations aren’t even the most important tool of contractionary monetary policy. The Federal Reserve can also use a tool called interest on reserve balances (IORB). This is a relatively new tool that essentially sets a minimum interest rate. How?
Well, the Federal Reserve offers to pay banks to keep money in reserves rather than lend them out. So if banks are offered 3% to keep money in the bank rather than lend it out, banks would never be willing to lend for less than 3% interest. In fact, given that loans are relatively risky, banks probably would need a good deal more than 3% to compensate them for the risk.
Since the pandemic began, the Federal Reserve has increased the IORB rate from 0.1% in March 2020 to 3.9% today. This is the amount banks get paid to not loan reserves, so the interest rate to loan them (to other banks for example) will be higher.
The Federal Reserve also offers to lend to banks at a rate called the discount rate which currently sits at 4 percent. So if banks can borrow for 4 percent and get paid 3.9 percent not to lend, there is a very narrow window for banks to lend to other banks. Interest on reserves is playing a much more direct role on monetary tightening than ever before.
Is a Soft Landing Possible?
Admittedly, insofar as the Federal Reserve policy was holding interest rates below what the market rate would have been, this is a positive change. But there is no way to completely undo behavior affected by monetary policy.
If the Federal Reserve impacted the long-term investment plans of businesses with expansionary monetary policy during COVID, this means that it caused businesses to take on projects they would not have taken on absent the policy. And when long-term projects begin, they can’t simply be reversed without a cost.
Imagine, for example, a business decided to build a new headquarters in light of the new lower Federal Reserve interest rates. Insofar as lower rates convinced the business to take on the new project, the higher rates represent the fact that those projects are rendered undesirable once again.
The problem is, the business can’t roll back the clock to put the stone, wood, and metal used in construction back in the ground. These resources have been irreversibly malivested. Changing course now would cost even more resources. Short of time travel, there is no returning to the way things used to be.
This example reflects the fact that the goods used to produce other goods (capital goods) are heterogeneous.
So how bad of a problem is this? It’s difficult to say. Insofar as businesses properly anticipated the Federal Reserve's actions, they may have not taken on any mistaken projects. But no economist believes every person always forecasts 100 percent correctly. And even if people are right “on average,” that still means at a given time some people are wrong.
If expansionary monetary policy has any impact at all, then, some of the impact will always be irreversible. A counter argument might be that Federal Reserve policy doesn’t impact the economy, but this begs the question, why would it engage in monetary policy at all if there were no impact?
This doesn’t mean contractionary monetary policy is a bad thing. Allowing market interest rates to rise insofar as that reflects the supply and demand in the market isn’t a bad thing.
Even setting interest rates directly can’t turn back the clock, though. Real resources are expended when businesses are impacted by Federal Reserve policy, and no amount of tightening will bring those resources back.