Since September, Jerome Powell’s Federal Reserve System has been cutting rates as if a financial crisis were looming. Just as in 2006, Powell raised the federal funds rate to 5.25 percent in the summer of 2023 and left it there until September of the following year. This past September, he cut rates by 50 percent in September and by 25 more basis points at the following Fed meeting just as Fed Chairman Ben Bernanke did Starting in September 2007. We all know what happened next.
That’s where the similarity ends, however, when it comes to overall monetary policy. When Bernanke started his cuts in September 2007, he did so the way the Fed had always done so, with open market operations. The Fed began buying government securities from its member banks, thereby increasing the supply of dollars available to those banks, which forced the federal funds rate down. That’s not the way it’s done anymore.
After Bernanke embarked on what he euphemistically called, “quantitative easing,” which is basically doing the same open market operations on steroids, a new dynamic emerged. Since the member banks accumulated large deposits at the Federal Reserve, something they never had before, interest rate policy became separated from management of the money supply.
No longer did the Fed accomplish a lower fed funds rate by buying securities to supply member banks with more dollars. It now could simply lower the interest rate it paid on member bank deposits at the Fed to incentivize member banks to lend to each other at a lower rate. Doing so without actually increasing the base money supply will encourage commercial bank lending but does not have the exponential effect that both lower interest rates and more “base money” can have.
Commercial banks also create money when they lend on a fractional reserve, but it is limited compared to the money created by the Fed. If the Fed lowers interest rates, commercial banks are incentivized to make more loans, creating new money, but that money is “destroyed” once the loans are repaid. Thus, commercial bank monetary inflation reaches an equilibrium point, with occasional deflations, if the Fed doesn’t change the money supply.
The same money creation and destruction dynamic applies to the Fed itself but on a much larger scale. Money is also destroyed when loans held by the Fed are paid down, thus decreasing the base money supply. But the Fed has always been a net creator of money over the long term, which is why consumer prices have always increased over the long term.
That brings us to today, where the Fed seems to be unburdened by what has been, as Vice President Kamala Harris would say. That’s because unlike in autumn 2007, when the Fed’s balance sheet increased by necessity to achieve its first two rate cuts, its balance sheet has decreased since beginning cuts this past September. This is just continuing the monetary tightening the Fed began in 2022 when its balance sheet peaked at $8.9 trillion. Through August of 2024 it has reduced its balance sheet to $7.1 trillion and kept on reducing it right through its September and November rate cuts to $6.9 trillion, where it stood as of its November 21, 2024 release.
So, the Fed is lowering the federal funds rate while decreasing the money supply. So, is it loosening or tightening? One could make an argument either way and it gets even more complicated than that.
Read the rest at Tom’s Substack…
Tom Mullen is the author of It’s the Fed, Stupid and Where Do Conservatives and Liberals Come From? And What Ever Happened to Life, Liberty, and the Pursuit of Happiness?
