Economists and Wall Streeters will often tell you that the Fed influences the economy by pumping money into the banking system, or by lowering or raising interest rates. But they don’t tell you exactly how the Fed does that.
That’s because most of them don’t know…and the ones who do know don’t like to talk about it.
Let’s put aside interest rates for a moment. The Fed completely screwed that tool up by injecting $2.7 trillion of cash into the banking system. With that amount of money in the system, rates don’t matter much.
All that matters is whether that huge pile of cash is increasing or not.
From 2009 until the end of 2014 under its “quantitative easing” program (or QE), the quantity of money in the system was always growing, except when the Fed took a brief pause. And the markets always rose, except when the Fed took a brief pause.
That was no accident.
Wall Street would have you believe that the Fed prints money and somehow it gets into the US economy and then by osmosis into the stock market.
In fact, it’s just the opposite.
Today, I want to take you inside the Fed’s secret “back room” and give you a look at how the sausage is made…
How the Fed Creates Money Out of Thin Air
The Fed creates money through something called Open Market Operations (OMO).
In Open Market Operations the Fed buys bonds from the Primary Dealers – mostly Treasury bonds and mortgage bonds guaranteed by the government (sometimes the Fed buys up much more risky bonds – but those riskier bonds are a separate issue – you’ll hear more from me on that soon).
What’s important today is that when the Fed buys a bond from a Primary Dealer, it credits the dealer’s Fed account with cash. The dealer gets cash in exchange for the bond it sold to the Fed.
Where did that cash come from?
Nowhere. The Fed created it. It didn’t exist before that. This is the essence of money printing and the policy of QE. The money did not exist before the Fed purchased the bond. The dealer’s resulting cash deposit becomes the dealer’s asset held on deposit at the Fed.
If you know where to look, you can actually see the deposits that the Primary Dealers make. They are lumped together in a line item called “Other Deposits” on the Fed’s weekly H41 statement, which I track. That line is highlighted below…
While QE was going on, there were massive swings in this line item from week to week as the cash flowed into these dealer accounts, then flowed out when the dealers moved the cash to somewhere where they could buy stocks.
To summarize, the Fed just creates money out of thin air. They use that money to purchase bonds, transferring the money to the Primary Dealers. The Primary Dealers then go out and buy other securities. They buy stocks.
You know the first rule of economics – price is set by supply and demand.
All that cash in the system created a lot of demand for stocks. Meanwhile, the supply of stocks wasn’t growing – in fact, supply was shrinking. Money got so cheap that corporations realized that it was cheaper to buy back their own stock than to invest in plant and equipment, or their labor force.
Increasing demand and decreasing supply equaled rising stock prices.
It really is that simple.
Primary Dealers Make It Happen
For all the talk about earnings and recession and “animal spirits” and Obama and Trump and whatever else you see on the news, the price of stocks is an Economics 101 result of supply and demand. And the increasing price over the past eight years has been because of lots of demand and a shortage of supply.
The constant flow of cash from QE the Fed turned that into a one way street on the buy side only.
Economists and Wall Street pundits are typically ignorant of the fact that there’s only one way for the Fed’s monetary policy transmission to the economy. That’s via the Primary Dealers who then trade with counterparties. When the dealer purchases securities from another party, the cash goes into that party’s account, and then gets deposited in a bank account. From there that cash moves to another line item on the Fed’s balance sheet called “other deposits held by depository institutions.”
That line item is more commonly known as bank reserves. It is part of the monetary base. That’s how Fed policy decisions make it to the banking system. It doesn’t go through the banks first then magically boost the economy. It starts as a Fed trade with a Primary dealer and ends as a Primary dealer trade with any counterparty. It could be a bank or investment institution, or even you and me. It’s the second trade that transmits the Fed’s new money into the banking system.
But that’s not how most of it gets into the economy. That new money is often confined circulating in the financial markets where it keeps the market pot boiling and bubbling.
Many bears are fond of saying that the money never leaves the Fed’s balance sheet and never boosts the economy. That’s BS, too. The money exists both on the Fed’s balance sheet as a liability and in the banking system as a cash asset.
It exists in two places at once because that’s just how the world of money works. It’s called double entry bookkeeping or accounting. We live in a double entry world. When the Fed creates the money, it is instantly available in the banking system. It’s not somehow imprisoned at the Fed. That’s a fairy tale.
Here’s how some of the new money gets into the economy.
The dealers not only conduct subsequent trades with other counterparties (such as buying stocks or lending), they also turn right around and use some of the cash to buy Treasury notes and bonds at the next week’s Treasury auctions.
That’s right – the cash that did not exist before the Fed created it is then used to pay the US Treasury for its newly issued paper. The cash that the dealer sends to the Treasury in payment for the new bonds goes into the US Treasury account at the Fed.
So the money that the Fed just printed two weeks ago is now in the hands of Uncle Sam.
The Fed may not directly buy securities from the Treasury, but it certainly does so indirectly. Any pretense to the contrary is just make believe. Whether it does so directly or indirectly doesn’t matter – the Treasury still ends up with some of the money.
In fact, if the Fed bought the bonds directly, it would not have pushed securities prices up so much because it would bypass the Primary Dealers. By including them as the conduit for the financing, the Fed could first inflate stock prices, then finance US government spending.
And that’s how the money enters the economic stream.
The dealers use cash from the Fed to buy government paper. The government subsequently uses that cash to cover its deficit.
In other words, to pay its regular bills, the Federal Government spends the cash that the Fed printed a couple of weeks ago.
If you’re on social security, some of that newly printed Fed cash just ended up in your bank account. Or it went into the accounts of military contractors, government employees, nursing homes who get paid by Medicaid, and so on.
The most important point is that when the Fed prints money, it first boosts the financial markets. It does eventually reach the economy, but that’s secondary.
Soon the Fed will start “normalizing” its balance sheet. That will drain cash from the banking system – reducing demand and maybe even increasing supply. Economics 101 works in reverse, too.
But the Fed’s process for removing money from the system will not be a mirror image of how they put it into the system process. It will work differently, and it will influence the economy differently.
I’ll be with you every step of the way to let you know what the Fed is doing, and what it means for your money.