Note January 24, 2024: Hi; I’ve been getting a lot of hits to this post lately but can’t track them back. If you got here from a link and don’t mind telling me what it is, could you do so in the comments? Just curious. Thanks, Neurotoxin.
Hey everybody, inflation’s back in the headlines! Suffering from social embarrassment because you can’t follow discussions of economic policy? Lonely because that cute guy you like only dates girls who understand the Taylor Principle? Have you been bullied because you confused the Fed and the Treasury? We’re here to help! Here’s a primer on US monetary policy and related matters.
Executive summary: Inflation is a rise in the general level of prices of goods and services. In the long run inflation is caused by increasing the amount of money in circulation.
1. The Federal Reserve System. The USA’s central bank. A central bank is not actually a bank. It’s the part of the government that prints the money.
(The issuers of various kinds of US money are the Federal Reserve System, the Treasury, and the Mint, jointly. But the first of these is the institution that handles monetary policy; see below.)
Everyone calls the Federal Reserve System “the Fed.” The Fed was legislated into existence in 1913. Aside from controlling influencing the supply of money, it has the power to create regulations that affect broad swathes of the financial sector (particularly banks), and to “interpret” regulations created by Congress and the President.
2. “Dollars.” The two most liquid forms of dollar-denominated assets are literal paper dollars and dollar-denominated electronic reserves. Electronic reserves are simply numbers in a Fed computer. Those numbers are assets of commercial banks (i.e. actual banks) and similar financial institutions. Banks can have reserve accounts at the Fed. You and I can’t.
Electronic reserves are money for two reasons: One reason is that everyone accepts them as money, i.e. as media of exchange. You go to the sex store and buy a 5-gallon barrel of lube, a 7-speed vibrator, and a pair of crotchless panties for $100. You swipe your card through the reader and payment has been made.
(This process decreases the balance in your checking account by $100 and adds $100 to the sex store’s account at its bank (or similar financial institution). The two banks talk to each other, via the Fed, which debits your bank’s reserve account by $100 and credits the sex store’s bank’s account by $100. BTW, the process is not actually as instantaneous as it seems. Also, it’s not always mediated by the Fed, which subcontracts out some of this payments-clearing stuff.)
The second reason that electronic reserves are money is that if a bank requests it, the Fed will ship paper money against their electronic reserves at one-for-one. E.g. the Fed will lower the bank’s electronic reserve account number by $50 million and ship it $50 million in paper dollars in an armored truck.
While I’m on the subject: take out a dollar bill and note the “legal tender” language. This is what people mean when they call dollars “fiat money”: another reason they’re money is legal fiat. See below for more.
3. Treasury securities (bills, notes, and bonds). Yes, this is relevant for monetary policy; bear with me. These are basically IOUs the Treasury sells when the federal government needs to borrow money. The buyers of these securities are lending money to the federal government. The simplest version of this is a piece of paper which— well, they’re not generally paper any more, but anyway— a piece of paper that works like this: A 6-month Treasury note, which the Treasury sells on June 1, 2022, says
“The US Treasury will pay the holder of this piece of paper $1,000 on December 1, 2022.”
On June 1, 2022, someone buys that note for some amount smaller than its face value of $1,000. (The price the Treasury can get for it is determined by conditions in financial markets.) That allows the buyer to earn interest. For example, say you buy it for $990 on 6/1/22. Then on 12/1/22 when the Treasury gives you $1,000, you have gotten back the $990 you lent to the government plus $10 of interest. So you’ve earned a six-month interest rate of $10/$990, or about 1%. (Note this is not the implied yearly interest rate.)
So the note earns interest because it sells at a discount from its face value. So this is called a discount bond. Since it makes no “coupon” payments before its maturity it’s also called a no-coupon bond. Coupon bonds make a sequence of payments, at least one coupon payment before their final payment.
State and local government bonds and corporate bonds work the same way, terms of their basics, as Treasury bonds.
4. Why do some people say that (a lot of) modern money is “debt”? First note that money is anything that is generally accepted in exchange for goods and services. (“Money” is defined by a list of several features, but that’s the headliner.) If I can go into a sex store and walk out with a 5-gallon drum of lube, by swiping a card that’s connected to my checking account, then the number in my checking account is money.
Thus, impeccably conventional measures of the money supply include numbers in checking accounts. (The way the law usually works— things are different at the moment due to COVID— is that for every $1 in electronic reserves that a bank has, it’s allowed to have up to $10 in checking accounts on its books.) Notice something: While the number in your checking account is an asset from your point of view, it’s a liability from the bank’s point of view. Why? Because they have to surrender that money if you direct them to. They have to either give you paper dollars or they have to make payment to a third party (the sex store, e.g.) when you swipe your card or write a check.
So a lot of modern money is something that appears on the liability side of some financial institution’s balance sheet. Thus, debt.
5. Monetary policy. The changing of the money supply to achieve certain economic goals, one part of economic policy. There is more than one kind of monetary policy, especially in, say, a pandemic in which the Fed is crazily improvising, but normally the main one is a simple thing with a complicated name: open market operations (OMO).
OMO is simply the Fed buying and selling Treasury securities.
When the Fed wants to raise the money supply by say $10 billion, it simply buys $10 billion of Treasury bonds (bills, or notes, whatevs). It credits the bond sellers’ accounts (or their banks’ accounts) with $10 billion of reserves. Where do those reserves come from? The Fed just types them up. People at the Fed raise the number in the reserve accounts in the Fed’s computers.
So the Fed has removed $10 billion of T-bonds from the economy and injected $10 billion of money. This increases the supply of money, colloquially “printing money.”
If the Fed wants to decrease the money supply it sells bonds. The Fed gives (say) $10 billion of T-bonds to various bond buyers, and they make payment by giving the Fed $10 billion of reserves. Then the Fed destroys those reserves. How? It just lowers the number in the relevant reserve account. Where does that money go? Like love in that old J. Geils Band song, it’s gone, that’s all.
6. Inflation. Inflation is a rise in the general level of prices of goods and services. In the long run, inflation is caused by money creation.
Everyone in the world who is knowledgeable about this topic knows how to stop inflation: Stop printing money. This might not happen for two possible reasons. One reason is that the central bank believes (rightly or wrongly) that the economic costs of stopping the inflation would be worse than the inflation. The other is political stuff. E.g. maybe the government’s executive branch is (for various reasons) pressuring the central bank to continue the money printing.
7. Interest rates. What’s all this talk about interest rates in monetary policy? While monetary policy is (by definition) the changing of the amount of money in circulation, most central banks usually think about policy through an interest rate channel. That is, the supply of money affects interest rates— take this on faith please; this post is already longer than I planned— and interest rates affect other stuff that we actually care about, like GDP, the unemployment rate, etc.
When you contract the money supply you stop and indeed reverse inflation. You also (in the short run) cause interest rates to go up (take on faith). So people say things like “We need to raise interest rates to stop inflation.” I think this is an unfortunately roundabout way of expressing it.
8. Miscellaneous items.
(A) Because central banks often think about policy in an interest rate way, here’s an important distinction: Nominal interest rates are not adjusted for inflation. Real interest rates are.
Provided the numbers involved are not too large, the adjustment is extremely simple: The real interest rate is just the nominal interest rate minus the inflation rate. Ex: If the nominal interest rate is 7% and the inflation rate is 4%, then the real interest rate is 3%.
If a central bank is going to think about monetary policy in the (unfortunately roundabout, IMHO) interest rate way, it’s important to make sure that it’s adjusting the real interest rate in the right direction in response to events. Thus it is a truth universally acknowledged that a zombie in possession of brains must be in want of more brains. I mean, it is a truth universally acknowledged that when inflation rises, the nominal interest rate must rise even more, to make sure the real interest rate rises. (This called the Taylor Principle.) Fed policy over the last 8 months or so has not been respecting this principle, which everyone at the Fed is aware of. The reason for this is…?
(B) Fiat money. “Fiat” means force. Fiat money is supported by force because e.g. if you don’t want to pay your taxes in dollars the IRS guys won’t be amused, and legal compulsion will enter the situation. Try to pay your taxes next year in Doritos or fish heads; observe results.
(C) “The Fed’s balance sheet.” When the Fed buys Treasury bonds or other kinds of securities it holds them on its balance sheet. The dollar-denominated reserves that the Fed created to buy those securities are booked as a liability on its balance sheet. (Though they’re not really a liability in any economically meaningful sense.) For this reason, when the Fed creates money, the gross size of its balance sheet grows. The net size doesn’t change, since newly-acquired assets (T bonds or whatever) are matched by an equal amount of newly-created liabilities (electronic reserves). My point being: When finance-y people say “The Fed’s balance sheet has grown” they’re saying, rather obliquely, “The Fed has been printing money.”