Questioning Assumptions about The Federal Reserve (Part III)

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A Second Loop – New Assumptions About the Fed

The recent explosion in price inflation has caused many commentators to ask, “When will the Fed act to tame this inflation?” “When will the Fed raise interest rates?” In response to the price inflation, the Fed has recently “raised rates” by 75 basis points (or .75 percentage points.)

These comments and the Fed’s actions provide an excellent opportunity to examine some people’s assumptions about the Fed and its influence in financial markets.

The Fed Creates “Money”

As a background for this comment, here’s a precise definition of money:

Money consists of any economic good, or any claim on such a good, that serves as a general medium of indirect exchange and that acts as a final means of payment.

People have believed for a long time that the Fed creates money. The assumption goes that when the Fed adds dollars to a bank’s reserve account, it creates money.

Whether or not a commodity qualifies as money depends on its use. One qualification criterion requires general acceptance as a means of final payment. Most dollars meet that criterion, but some dollars do not. Dollar-denominated checks drawn on commercial banks meet that criterion. Dollar-denominated account balances held at the Fed do not meet that criterion. The general public cannot have accounts at the Fed, and banks cannot transfer their ownership of their Fed account balances to the public; therefore, those balances cannot act as money.

The misconception that the Fed created money must have arisen in the period when banks had limited excess reserves. When the Fed increased the amount of excess reserves (denominated in dollars), banks would use their increased capacity to create money (denominated in dollars). The correlation between reserve increases and monetary increases led to confusion between correlation and causation.

Ben Bernanke’s Fed exposed the fallacious assumption about the Fed’s money creation when the money supply expansion did not keep pace with his monstrous increase in bank reserves. With banks flush with excess reserves, the Fed lost its leverage on banks’ money creation capacity. This move simultaneously turned the Fed into a paper tiger.

The Fed finally gave up the subterfuge and eliminated reserve requirements. But no one seemed to notice. They still talk about what the Fed can do about inflation. Can the Fed really do anything?

The Fed cannot create money.

Setting Interest Rates

If a person listens to the financial news, it will not take long before they hear commentators refer to The Fed raising rates to stifle (price) inflation. These statements imply the assumption that The Fed actually has the power to change interest rates unilaterally.

Eventually, you might hear them refer not to rates in general but more specifically to the Fed Funds Rate. Somehow The Fed can intervene in a market in which it does not participate directly and raise the rates at which Fed Members trade reserve balances.

The Fed cannot unilaterally change any interest rate. No one can.

Significance of Fed Funds Rate

Financial markets deal in many debt instruments that vary in type and term. The general term “interest rates,” without reference to specific rates, has no precise meaning. The claim of controlling “interest rates” generally refers to the Fed Funds rate—or interest paid between banks for the overnight exchange of bank reserves. Thus, to understand this statement, we need to examine the assumptions about the rate on the exchange of reserve balances, i.e., Fed Funds.

So, does the Fed Funds rate act as a bellwether or base for any other rates?

When banks had to meet reserve requirements, the Fed funds rate acted as a bellwether. When banks experienced relatively high demand for credit, they tended to have lower levels of excess reserves. As a result, banks tended to pay more to cover temporary shortages in their reserve accounts. Thus, the Fed funds rate acted as a sort of bellwether. (Since the tenure of Ben Bernanke, the Fed funds rate has no real significance as a bellwether.)

But did the Fed funds rate act as a base rate?

A particular form of debt must be available to a relatively broad market to act as a base rate. Fed funds transactions, however, exist in a closed market. Only banks can trade bank reserves. Even the Fed does not trade directly in the Fed Funds market.

We must examine Fed Funds’ significance in the current zero reserve requirement environment. The Fed no longer reports the level of excess reserves. They don’t seem to see any significance—and there is none. What motivation do banks have to buy and sell reserves when reserve balances have no importance?

The Fed Funds rate has no direct impact on market rates. It has an influence only because people talk about it too much.


Excess reserves have become meaningless in the current zero reserve requirement environment (The Fed does even report them). Hypothetically banks could create an infinite quantity of money. I will explain why they don’t create more money in another article.

The Fed does not create money; only the market decides what to use as money. You cannot own the dollars created by the Fed, and thereby you cannot use them as money. You can only use the dollars created by banks as money.

The Fed cannot “set (or raise) rates.” Interest rates only change when the amount borrowed or the amount repaid changes.

The Fed Funds rate does not act as a base rate because Fed Funds trade in a closed market.

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