Edward Lotterman
With President Donald Trump using any means to force the Federal Reserve to pump up the money supply, that institution and that variable remain the focus of news. That certainly will remain over the next 18 months as results of his other policy changes, many still yo-yoing on a daily basis, work their way through the larger economy.
The column last week explained basic concepts of money and the history of banking in our country. It ended at Congress establishing 12 Federal Reserve Banks in 1913. These could expand and contract available money to meet the needs of an expanding economy. They also could intervene as needed to prevent banking-sector crises that touched off major recessions. These scourged the poor harder than anyone else.
When a local commercial bank in a district was short of cash, whether to meet depositors’ withdrawals or to make more loans to merchants and farmers, it could borrow from its district Fed’s “discount window.” The Feds demanded collateral. Promissory notes already made to local banks on earlier loans filled this need. If a bank did not repay its loans from the Fed, that institution had rights to principal and interest paid by the original farm or business borrower.
Loans the Fed made were less than the value of promissory notes presented as collateral. If a local bank came with $10,000 in IOUs seeking money for six months, it might get only $9,750 from the Fed. After six months, it would repay $10,000, of which $250 would be interest. This deduction or “discount” for the borrowing local bank was why such borrowing was said to be at the “discount window.” Interest paid was the “discount rate.”
The crucial point here, often not understood, is that the Fed need not have any money in its possession to make such loans. It simply created it out of nothing with a few pen strokes in a ledger. No gold or silver or anything from the U.S. Treasury was needed.
All local banks had “reserve accounts” with their Fed holding at least the fraction of their deposits as law required. In making a loan, the Fed merely altered the accounting entry, so the new money appeared in the local bank’s reserve account and could be drawn on.
This boggles minds of many intro econ students. They are boggled even more when told that the Fed creating a new $10,000 out of nothing for one borrowing bank could increase the total national money supply, currency plus bank deposits, several times. Perhaps $30,000 or $50,000 or even $100,000 would be added to circulation. (No, it cannot be explained here. Just accept it as true.)
Such discount lending could meet the challenges of local banks seeing increased loan demand or satisfying panicked depositors. Unfortunately, when faced by a national downturn, 12 legally unconnected banks had no way to initiate a response.
Fortunately, the New York Fed president was Benjamin Strong, an unrecognized great American. He had been J.P. Morgan’s right-hand aide in stemming a disastrous bank panic in 1907. In 1914, Strong gave up a future of great wealth to accept a moderate salary as president of the most important new regional Fed bank. Strong learned that when a lack of liquidity overwhelmed multiple banks, leaving them unable to make new loans while also struggling to meet depositor withdrawals, the N.Y. Fed need not wait for such banks to come in.
If the Fed simply went to open markets for government bonds and bought some with money created out of thin air, it would create greater liquidity for the entire banking system. Smaller Fed banks like Minneapolis, Cleveland, Kansas City or Dallas could not. But with New York the center of finance for the nation as a whole, the New York Fed carrying out such “open-market operations” affected all regions.
Understand, however, that a danger loomed: Excessive available money could cause inflation.
In that case, the district Feds could raise their discount rates, discouraging local banks’ borrowing. As existing loans were paid off, the money was simply “destroyed.” The New York Fed did the same by selling previously purchased Treasury bonds in open markets. The money it got in payment simply disappeared.
(Yes, this is hard to understand. Buy a used introductory macro econ text and read the chapters on money, banking and central banking.)
Returning to history, the 1929 stock market crash threw financial markets and banks of all sizes into disarray. Strong had died at age 55 of tuberculosis 12 months earlier. The decentralized Fed system was leaderless. It and the U.S. Treasury stood around like law enforcement officials at the Uvalde school shooting. They twiddled their thumbs and tsk-tsked as catastrophe unfolded. When historians assert, “If Ben Strong had not died, the Great Depression might never have occurred,” they have a good case.
In 1933, President Franklin Roosevelt and a new Congress passed legislation that restructured the Fed into a national system with a seven-member Board of Governors. These plus 12 District Bank presidents made up a 19-member Federal Open Market Committee. It would meet periodically to make policy decisions. All members would deliberate, although only five of the presidents would vote in an annual rotation.
That is the system we have today. Discount window lending has almost disappeared. However, the Fed buys and sells Treasury securities, or short-term derivatives thereof, daily. It does not set any interest rate. It just increases and decreases the money supply.
Yes, it does set targets for one extremely-short-term rate. This is the “Fed funds rate” paid on 24-hour loans between commercial banks on money they must have in legally mandated reserve accounts kept at their district Feds. Since 2008, the FOMC has set upper and lower limits for this rate. Current ones, from 4.25% to 4.5%, were set last Dec. 18. Rates actually paid to each other hover around 4.33%.
Now, understanding that this rate in itself has little intrinsic importance is crucial. It matters only in its relationship to quantities of money the Fed creates from nothing or destroys without a trace.
In emergencies, such changes can be huge. The Fed created 370 billion new dollars, in the category of M2, currency plus bank deposits, in one week after the first U.S. COVID-19 case was identified in a Washington state nursing home on Jan. 20, 2020. By the time it peaked in mid-April 2022, M2 was up 39.2%, some $6.25 trillion. Hence the inflation that decided a key election.
However, before that election, the FOMC raised its Fed funds target stepwise from 0.25% to 5.5%. To do that, it had to destroy $1.2 trillion of the money supply. These cuts hit bottom in September 2020, about 30% above the 2020 starting point.
However, as the FOMC first held this overnight rate target and then began to drop it in 2024, the Fed had to return to increases in the money supply. The upshot is that we are $6.3 trillion, or 39.7%, above our pre-COVID bliss 4½ years ago.
So, in trying to force interest rates lower, Trump is demanding to further inflate an already historically high money supply even more. He is ignorant of that, but buyers and sellers of bonds and mortgage lenders understand it well. Trump doesn’t understand that markets, not Fed governors, are in the driver’s seat. Forcing overnight rates lower will drive long-term rates higher as inflation looms. No well-informed and sane person would want to go into the 2026 election with mortgage and medium-term farm and business loan interest rates rising, but our president seems hell-bent on that.
St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
