Can the FED Control Inflation?

The cost of living has been increasing over the past year and most people have started to notice. Just in June, the Consumer Price Index (CPI) jumped to an annual rate of 5.4%, the highest rate since August 2008. Jerome Powell, the chair of the Federal Reserve (FED), claims that the inflation is transitory and will end when the economy starts to open more, and supply and demand stabilize. However, when looking at the role the FED plays in the modern economy, it is difficult to truly believe that Powell is correct and that the FED will have the power to correct inflation if it does become more extreme.

The FED was created in 1923 to be the lender of last resort to the banking system. All banks in the US have an account at the FED where they store their remaining money (FED deposits) and lend it to each other to fulfill their legal reserve requirements. The FED is mainly known for adjusting the federal funds rate (FFR) which is the target interest rate that banks borrow and lend money to each other in the overnight market. The higher the interest rate, the more expensive it is for banks to borrow money and therefore will need to charge commercial borrowers (like me and you) higher rates to borrow money. This slows an economy since higher rates makes borrowing money less attractive. The reverse is true as well. When the FFR is lowered, it allows banks to compete for the lowest rate they can charge borrowers, which speeds up an economy since there will be more lending.

A second important point to know historically created most of the money. When someone deposits $100 at the bank, it is taken and $90 is given to another person in the form of a loan. That means $190 exists but is only backed by $100. This is called fractional reserve banking and the money multiplier effect.

There is a second player that can produce money – the Treasury. They can issue Treasury bonds, notes, and bills (all referred to as treasuries) which borrows money from the public and promises to repay with a small level of interest. While this does not actually create money, treasuries are often used as currency and can be used as the equivalent of money. In 2008 the FED began buying these treasuries in the open market in a program called Quantitative Easing (QE), which converts these treasuries into FED deposits in the bank’s FED account. In other words, the Treasury borrows money from the public and the FED turns the loan into new cash. The idea is two folded: One, it adds money to the system which means banks can lend at lower rates and attract more borrowers – thereby stimulating the economy. Second, it keeps money market rates low so that companies can issue bonds at very low rates – also stimulating the economy.

While it may seem no different if the banks create money through fractional reserve banking or the FED through QE, there is a major difference. Banks are only able to create money if there are borrowers willing to accept the loans. If the FFR is raised, demand for loans will decrease and new money creation will slow down. On the other hand, the Treasury is not bound by the FFR and can issue as many treasuries as it needs to fund the government’s deficit spending.

Historically, banks created most of the new money, while deficit spending only created a minor amount. Beginning in 2008, treasuries have outpaced bank credit, and in 2019 it spiked much higher. While banks can be controlled through the FFR, the Treasury cannot. Additionally, a large part of the government spending is ending up in the hands of private citizens (PPE, stimulus checks, etc..) which pushes more spending than the financial programs in 2008. Inflation has therefore become a political decision instead of a monetary decision. It depends on how much congress plans on deficit spending and giving money to the American people, and it is unlikely that the FED and Powell will be able to control the creation of new money and future inflation. In 2020 the government spent $3 trillion, while the FED has slowly been converting those newly issued treasuries into FED deposits through QE.

Can the FED stop the QE process? They can, but unlikely will as long as they are trying to keep money market rates low and continue boosting the economy. Additionally, if QE stops, treasury yields will rise which can cause havoc as well.

Since a large number of treasuries were issued at low interest rates, increasing the interest rate would devalue many of the bonds, which would hurt financial institutions. This could be a second handicap for the FED in terms of being able to raise interest rates to curb inflation. The last time the FED raised their rates to 2.5% in December 2018, the S&P 500 dipped heavily, forcing the FED to lower the rates. It is likely that with all the new treasury issuances at even lower rates, the market may be unable to tolerate a fed rate lower than 2.5%.

Therefore, as long as the Biden administration plans on high spending, it may be reasonable to conclude that inflation will continue to rise, and QE will keep going. How inflation will be moderated will remain a question yet to be answered.