How does the Fed 'manage' money?

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Q: We all are aware that the primary job of the Federal Reserve is to manage the money supply.  In simplest terms, if the economy is growing at 3 percent per year, as an example, then the money supply needs to also grow at approximately that rate in order that there be the currency in the market to support the additional economic activity.  When the money supply grows too fast, relative to the economy, we have inflation.  When the money supply grows too slowly, it can throttle economic growth, as there isn’t enough money to go around in support of real economic needs. 

OK, all sounds good.  My question is, then, what are the exact mechanisms the Federal Reserve and the U.S. Treasury use to expand or contract the money supply?  It has to be more complicated than, “Well, they simply print more money and put it into circulation,” because, who would get this new money then?  It can’t just be given away!  I have heard and read that money supply growth occurs in two ways: (1) Banks are allowed to lower the percentage of deposits they must retain – this allows them to lend more money as a function of existing deposits; and (2) the U.S. Treasury (or is it the Federal Reserve, or some arrangement of the two?) actually buys back outstanding, previously purchased, U.S. Treasury bonds and bills, which puts more money into the system than existed previously.— Michael G., Hillsboro, Ore.

A: You’ve got the mechanics of the Fed’s job down cold and explained very simply. (Hey, would you mind filling in for us when we go on vacation?)

Of the two levers you describe, by far the Fed’s favorite is open market operations -– where it adds or drains money by buying or selling Treasury debt that's already been issued and is trading in the "open market." Every six weeks or so, the Fed's Open Market Committee meets to give the Fed's New York trading desk its marching orders. When it buys Treasuries, for example, the billions in cash it uses to pay for that paper is then available for banks to lend. So the money supply in the banking system (and the U.S. economy once that money is lent out) goes up. Reverse the process –- sell securities -– and money gets sucked out of the banking system. Seems like a foolproof way to manage the economy.

The problem is that the system was designed and set up early in the last century –- when most lending and borrowing was channeled through banks. Alas, that’s no longer the case. Take the mortgage market, for example, which is dominated by two federally-sponsored entities, Fannie Mae and Freddie Mac. These two institutions lend money to home buyers, bundle those loans as mortgage-backed securities, sell those securities to investors and then lend the proceeds to the next home buyers. This credit creation process takes place outside of the Fed’s control.

There are other vast pools of money that are outside of the Fed’s reach. Money market mutual funds take in billions of dollars worth of deposits and buy various forms of paper -– in effect, lending that money out -- at which point it goes back into the system. The derivatives markets also “create” money. An option (the right to buy or sell a stock at a fixed price within a set period of time) is simply a piece of paper created by an investor willing to place a bet on the direction of that stock’s price. As soon as that piece of paper starts trading, it has a monetary value over which the Fed has no control. And consider the vast wealth that has been created in the housing market. As homeowners tap that wealth with home equity loans, they're monetizing their paper profit. The creation of all of that “new money” is also outside the Fed’s control.

Strictly speaking, this expansion of credit and paper wealth is not the same as printing money. But it has essentially the same impact on the economy -– it increases purchasing power. And, since consumer spending represents roughly two-thirds of U.S. economic activity, increased purchasing power has a much great impact than the relatively few dollars in the banking system over which the Fed exerts direct control.

Even if the Fed were granted vast new powers over any and all dollar-denominated transactions (now there’s a scary thought), it still wouldn’t have complete control over inflationary pressures. For that, we’d have to have a global central bank; much of the current inflationary pressure is coming from outside the U.S. Oil prices, for example, are rising because global demand is approaching production capacity -- or at least oil traders are convinced that’s what’s happening. China’s booming economy is sucking up excess capacity for raw materials like steel and copper, which is pushing up prices of those commodities. No matter what the Fed does, these higher prices cut into the purchasing power of every U.S. dollar.

It’s not that the Fed is powerless – far from it. But the Fed’s control over the money supply – and the U.S. economy – is often overstated.