If you have read my previous M2 money supply and assets post, you will be aware that watching M2 chart with hawkish eyes is effectively monitoring the government’s money printing actions.
Or… is that so?
If you were the government and aware that most of the public closely monitors the M2 money supply metric, wouldn’t you want to have diverse methods to inject money into the economy when necessary, without drawing public criticism?
The Federal Reserve (Fed) has several sophisticated methods to create money without directly impacting the M2 money supply. These methods help manage the economy, control inflation, and ensure financial stability in the short term, but may lead to higher inflations in the long term.
Let’s dive into these methods with detailed explanations and data to make it clear. I’ve added some real-life, simplified examples as well to help you understand better.
Understanding M2
Before we explore the methods the Federal Reserve uses to manage the money supply, it’s essential to understand what M2 is and why it matters.
What is M2?
M2 is a measure of the money supply that includes a broader set of financial assets than the more narrow M1 metric. Here’s a breakdown of what M2 includes:
- Cash and Checking Deposits (M1): This is the most liquid part of the money supply, consisting of physical currency (coins and bills) and checking account balances that can be easily accessed for spending.
- Savings Deposits: These are accounts that earn interest and are slightly less liquid than checking accounts but can still be accessed relatively quickly.
- Money Market Securities: These include short-term financial instruments that are highly liquid and considered safe, like Treasury bills and commercial paper.
- Time Deposits: These are bank deposits that cannot be withdrawn for a certain “term” or period without incurring a penalty. Examples include certificates of deposit (CDs).
As of March 2024, the M2 money supply was about $20.8 trillion.
1. Reverse Repos
What is a Reverse Repo?
A reverse repurchase agreement (reverse repo) is when the Fed sells securities with an agreement to buy them back later. This action temporarily removes liquidity from the banking system without a lasting effect on M2.
How It Works:
- The Fed sells $50 billion in securities to banks, reducing their cash temporarily.
- Later, the Fed buys back these securities, replenishing the banks’ cash.
- This swap doesn’t significantly change M2 because it’s a temporary adjustment.
In 2021, the Fed used reverse repos to manage short-term interest rates and control liquidity in the financial system. By temporarily removing excess liquidity, the Fed could maintain stable market conditions without permanently altering the M2 money supply.
Real-Life Example:
Say you have a favorite toy that you (the Fed) don’t want to sell permanently, but you need some quick cash to buy snacks for a party. So, you make a deal with your brother (the banks): you give them the toy (the securities) to hold onto for a week in exchange for some money. You promise that after a week, you’ll buy back the toy from them.
In this situation, you get the money you need temporarily, and after a week, you get your toy (securities) back when you return the money. Similarly, the Fed uses reverse repos to temporarily manage cash flow in the banking system without making permanent changes to the overall money supply.
2. Combining Quantitative Easing (QE) and Interest on Reserves (IORB)
What is QE?
Quantitative Easing (QE) is when the Fed buys financial assets like Treasury bonds and mortgage-backed securities from banks. This action increases banks’ reserves, a form of digital money that stays within the banking system.
What is IORB?
Interest on Reserve Balances (IORB) is a policy where the Fed pays banks interest on the reserves they hold. This incentivizes banks to keep more reserves at the Fed instead of lending them out. Of course, Fed could utilize it the opposite way to encourage money lending activities. By using IORB properly, the Fed can effectively manage the money supply and control inflation while providing necessary liquidity to stabilize financial markets.
What happens if Combined?
Combining Interest on Reserve Balances (IORB) with Quantitative Easing (QE) allows the Federal Reserve to inject liquidity into the banking system without directly increasing the M2 money supply. When the Fed conducts QE, it buys long-term securities, increasing banks’ reserves. If the Fed simultaneously pays interest on these excess reserves, banks are incentivized to hold onto the reserves rather than lending them out.
This combination means the reserves stay within the banking system, and the newly created money from QE does not immediately flow into the economy as loans or deposits, thus not directly increasing M2. Voilà! Money was created but an increase in M2 chart nor the inflation did not happen (..yet).
How It Works:
- The Fed buys $100 billion in Treasury bonds from JP Morgan.
- JP Morgan’s reserves at the Fed increase by $100 billion.
- Then the Fed pays JP Morgan high interest to keep that $100 billion in reserves.
- This encourages banks to hold reserves rather than lending them out, keeping M2 stable.
When Fed lowers this IORB rate, it would then be beneficial for the banks to lend out the money instead of keeping it in the reserves, which will then increase M2. During COVID-19 crisis, the Fed adjusted the interest rate on reserves to manage economic conditions during the pandemic. In January 2020, the interest rate on reserves was 1.55%. By mid-March 2020, the Federal Reserve had dropped the rate to 0.1%, making relatively more lucrative for banks to increase lending.
3. Swap Lines with Other Central Banks
What are Swap Lines?
Swap lines are agreements between the Fed and other central banks to exchange currencies. When the Fed extends a swap line, it credits the foreign central bank’s account at the Federal Reserve with U.S. dollars, which the foreign central bank then lends to its domestic banks. These transactions are temporary and involve a promise to reverse the swap at a later date. This ensures global liquidity without directly affecting M2.
How It Works:
- The Fed provides $50 billion in swap lines to the European Central Bank.
- European banks get dollars, but these dollars don’t enter the U.S. money supply (M2).
During the COVID-19 crisis, the Fed established up to $450 billion worth of swap lines with several foreign central banks, including the European Central Bank and the Bank of Japan, to maintain dollar liquidity worldwide. This helped stabilize global markets without directly increasing the domestic U.S. M2.
Real-Life examples:
You realized that you and your friends are envious of each other’s different types of toys. So you (the Fed) suggests to swap toys (lines) with the friend (foreign banks) for a while, but neither of you actually loses or gains toys permanently. This swap keeps both of you happy and your toy collections balanced, just like the Fed’s swap lines keep global financial systems stable without affecting the U.S. money supply.
Conclusion
The Fed employs several sophisticated methods to create money and manage the economy without directly increasing the M2 money supply. These tools include reverse repos, combining QE and interest on reserves, and swap lines with other central banks. These methods ensure that the financial system remains stable and liquid while controlling inflation and supporting economic growth.
While these methods do not directly impact the M2 money supply, their effects should not be underestimated in the long run. They do increase overall liquidity in the financial system, and the added liquidity can boost confidence in U.S. financial markets, leading to higher deposits and increased credit creation. Over time, these factors can contribute to rising inflation as the effects of the increased liquidity permeate the economy. It is essential to monitor these developments closely, as the long-term impact can subtly influence inflation and the broader economic environment.
Let’s stay informed with proper knowledge on global liquidity to enrich our daily lives.
Happy investing!
