At least to date, stock markets have staged a relatively strong recovery from the deep losses they experienced when the COVID-19 pandemic began. That’s good news, right? Except you also may have heard unsettling suggestions that the recovery is just an illusion, propped up by the U.S. Federal Reserve (“the Fed”), which is printing huge piles of money.
How can all of this U.S. money-printing be good for the country’s currency? Should we be concerned that the illusion might end, followed shortly by a plummeting market, and/or rampant inflation?
Before we judge the Fed’s policies too harshly, let’s take a much closer look at what is really happening when you hear that the Fed is “printing money”.
By the way, I don’t intend to take a side on the inherently political debate over the involvement a central bank should have in the economy. My goal is to explain the mechanics of some of the policy tools the Fed and other central banks use, and explore their potential impact on currencies and financial markets.
To understand what “money-printing” means, and how it might relate to the stock market, we first need to understand what money is, and why it is important to any functioning capitalist economy. Money is three things:
When we talk about money today, we are talking about fiat money. Fiat means “let it be” in Latin. It refers to money that has no intrinsic value, but rather is used in an economy based on government pronouncement. Ultimately, the stability of fiat money comes from the productive capacity of the economy in which it’s being used, as well as the state’s endorsement and protection of its use.
In other words, fiat money is a social construct that facilitates economic activity.
Here is another important point: The government does not create most of the money in its economy. Governments are the only entity that can print physical currency such as paper bills and coins, but these are a small proportion of all the money in the economy.
Most money instead comes from private banks making loans to individuals and businesses. Every time a bank issues a new loan it creates two things:
This transaction represents money, electronically created out of thin air by private banks.
Savings and Loans … In Reverse
Private banks compete with each other every day to create money by issuing loans. The primary constraint that prevents private banks from over-extending themselves is their need to remain profitable. In other words, they cannot make too many loans to borrowers who don’t eventually pay them back.
This constraint on lending is very different from the stereotypical characterization of banking. More commonly, people assume banks take in deposits, and make loans based on those deposits. In financial jargon, this is described as fractional reserve banking and the money multiplier effect.
Call it what you will, it’s not how money actually flows in the modern economy. In both Canada and the U.S., private banks don’t even have reserve requirements. As long as a bank believes it will profit from a loan, it will make the loan, often covering it by creating electronic (“thin air”) money.
The practical implication of this virtual reality is that, contrary to common belief, borrowing is the money-creating process that allows for saving … not the other way around.
In a world where money is rarely a tangible object, private banks must naturally keep a close eye on their net flows as money moves through the system. Let’s say a bank extends a loan to a customer running a manufacturing business. If the customer uses the money to pay a supplier who uses a different bank, the money leaves the customer’s bank and moves to the supplier’s bank. The money remains in the private banking system, but the customer’s bank has had a net negative flow from the transaction.
Banks clear their net flows through a central clearing house at the end of each day, using a special kind of money called bank reserves. If more money leaves a bank than came in that day, the bank owes the central clearinghouse. The bank will cover this shortfall by borrowing reserves in the overnight lending market. A bank with a net positive flow for the day would lend their excess money to a bank with a net negative flow.
Where do customers’ deposits come into play? It’s typically cheaper for a bank to pay interest on deposits than to borrow in the overnight lending market. As such, they prefer to use deposits when they’re able. However, if a bank does not have enough deposits to settle their daily net flows, they know they can still settle them by borrowing from the overnight lending market. So again, either way, a bank will always make a loan if they expect it to be profitable, whether or not customer deposits are in hand.
This explains why the interest rate on overnight loans between banks is so important to the economy. If the overnight lending rate increases, then banks will need to charge their customers more for loans if they want to remain profitable. Central banks try to influence the overnight lending rates by supplying or removing liquidity from the overnight lending market.
So far, so good … as long as everything keeps chugging along. But every so often, economic engines can threaten to blow a proverbial gasket. In extreme cases, like the 2008 financial crisis, banks may have trouble settling their net flows in the overnight lending market.
If the system threatens to stall, central banks become important “mechanics” to the banking system, or a bank for the banks. Instead of allowing overnight lending rates to skyrocket due to illiquidity, they can create those aforementioned bank reserves out of more thin air, to provide liquidity to private banks.
This is why central banks are referred to as a “lender of last resort.” Setting targets for banks’ overnight lending rate is one way the Fed fulfils its charter to execute U.S. monetary policy (which includes (1) promoting maximum employment, (2) stabilizing prices, and (3) moderating long-term interest rates).
By changing the overnight lending rate, central banks can, to an extent, influence the demand for private bank loans from creditworthy borrowers. If interest rates are lower, more people should be willing and able to take loans, which should stimulate the economy. Raising the overnight rate should have the opposite effect.
One way central banks can influence the overnight lending rate is through open market operations, which involve transacting with private banks to add or remove bank reserve supplies from the system. To decrease the overnight lending rate, the central bank creates bank reserves to purchase short-term government securities from the private bank. Once the transaction occurs:
Again, once the dust settles, there is no net effect on the private bank’s balance sheet. In open market operations the central bank is not literally printing money to add to private banks’ coffers; they are creating bank reserves and swapping them for short-term government debt in an effort to influence short-term interest rates.
When the central bank purchases large amounts of assets from the private sector to lower the overnight lending rate, the private banks may end up with large positive settlement balances at the end of the day. When this happens, the central bank will pay interest on the positive balances. In that sense, bank reserves are really just another form of short-term government debt.
Influencing the overnight lending rate is considered a conventional approach to monetary policy. But what can a central bank do when the overnight lending rate is already at or near zero (like it is today), and more action is warranted? This happened in the U.S. during the 2008 financial crisis, and in Japan as early as 2001. In both cases, the solution was an unconventional monetary policy tool known as quantitative easing (QE).
Remember, it is routine monetary policy for a central bank to fabricate bank reserves to purchase short-term government securities from private banks. And private banks routinely create money every day as well. So, even though banks are “money-printing” daily, when people hear the term, they tend to associate it with QE.
That said, the execution of QE is nearly identical to conventional open market operations described – with a few key differences.
QE involves buying much larger amounts of longer-maturity government bonds and other private sector assets like corporate bonds and asset-backed securities. Otherwise, like other open market operations, QE is just another asset swap. The central bank creates bank reserves (the special money that banks use in the overnight lending market), and uses them to purchase private banks’ assets. The asset swap does not affect the private sector’s balance sheet, but it does alter the composition of the private sector’s assets, which is exactly what the central bank is hoping for.
The intention of QE is to reduce longer-term interest rates to stimulate economic activity. There are several theories about how it might accomplish that, including portfolio balance theory and signalling theory.
Portfolio balance theory suggests that removing huge amounts of longer-term government bonds, corporate bonds, and asset-backed securities from the open market and sticking them on the central bank’s balance sheet will increase these securities’ market prices in the private sector, reducing their yields. This shift in the yield curve could entice more businesses and individuals to borrow money, kickstarting the economic engine.
Signalling theory suggests that the central bank’s commitment to buying huge amounts of assets could signal their commitment to ongoing accommodative monetary policy, again making people more comfortable with borrowing and investing today.
Both of those theories also inherently suggest that QE should have a positive impact on stock prices. A more favourable environment for borrowing and an expectation of continued accommodative monetary policy should mean less perceived risk and a more favourable outlook in the market. Less risk and a better outlook should mean higher asset prices across the board, including for stocks.
Empirically, there is evidence that QE does impact stock prices. In a 2014 paper, “Evaluating Asset-Market Effects of Unconventional Monetary Policy: A Cross-Country Comparison”, the authors use an event study analysis to show that, within their sample, a 25 basis point surprise reduction in the 10-year U.S. treasury yield resulted in a 0.7% stock price increase. However, the authors also indicated unconventional monetary policy tools impacted equity prices less when short-term rates were already at or close to zero, like they are today.
None of this should be particularly surprising. When a central bank tries to stimulate the economy through an accommodative monetary policy action, market participants expect there to be a positive effect. This expectation, through various channels, is reflected in rising stock prices.
Frankly, I think it’s a bit of a stretch to say that central banks are single-handedly propping up the stock market. Monetary policy and expectations about future monetary policy are important inputs to the asset pricing equation. But there also are many others, including an unaddressed elephant in the room: inflation.
The bigger worry many people have when they hear about “money-printing” is the effect on inflation. Inflation was a major concern when the Fed originally rolled out QE in 2008. It even prompted a group of economists, professors, and fund managers to write an open letter to then Fed Chair Ben Bernanke, voicing their concerns.
Let’s remember what’s going on here. Banks are selling long-term government bonds, corporate bonds, and other assets to the central bank in exchange for bank reserves, which are really just another form of short-term government debt. This is where the disconnect between the image of money-printing and the reality of QE becomes evident. QE results in the fabrication of “thin air” bank reserves, leaving the net financial assets of the private sector unaffected. But there is no relationship between increasing bank reserves vs. private banks creating money by lending to customers (which could be inflationary).
The Fed examined this in a 2010 Finance and Economics Discussion Series working paper, “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?” The authors concluded:
“Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected. Specifically, our results indicate that bank loan supply does not respond to changes in monetary policy through a bank lending channel, no matter how we group the banks.”
The Bank of England similarly dispelled the idea that lending is related to bank reserves. In a 2014 bulletin, “Money creation in the modern economy”, they explained:
“Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them on to consumers in the economy, who do not hold reserves accounts. When banks make additional loans they are matched by extra deposits — the amount of reserves does not change.”
If anything, when central banks use unconventional monetary policy to stimulate economic activity beyond what was possible through conventional means, deflation is likely to be a bigger concern. We’ve seen this in Japan, where we have the longest-running QE experiment.
So, let’s circle back to our original question: Should you be worried when the Fed becomes a money-printer? We won’t answer the question for you definitively, but I think we’ve given you the resources you need to make a more informed decision. Here’s a rapid review:
Money is the medium that facilitates economic activity. Most of the money in the economy comes from private banks making loans to individuals and businesses. The demand for loans from credit-worthy borrowers is what dictates the amount of money in the economy.
Central banks like the Fed attempt to influence this demand by raising or lowering the overnight lending rate. When that rate is already at or near zero, they might use unconventional monetary policy to affect longer-term interest rates. This should increase asset prices, including stock prices, but it’s not sufficient to single-handedly prop up the stock market.
Finally, we believe it’s misguided to presume that central banks’ “money printing” will lead to inflation. QE is an asset swap that changes the composition of private sector financial assets without affecting the net amount of private sector assets. Further, private banks do not lend bank reserves to their customers. Money creation in the economy comes from demand for loans from credit-worthy borrowers. At a time when a central bank has decided that unconventional monetary policy is necessary, that demand must be low, meaning deflation is a bigger concern for the economy.
Before we wrap, there is one more point to consider: Should any of this influence your investment strategy? In a 2013 paper, “Does the Fed Control Interest Rates?” Eugene Fama demonstrated that the Fed’s target interest rate does not appear to affect long-term interest rates, plus there is substantial uncertainty about whether or not the Fed can even control short-term interest rates.
In other words, Fama suggested the Fed’s actions may have much less impact than we might suppose.
The stock market and inflation are both unpredictable. If they have any impact at all, a central bank’s actions are only one of many reasons this is true. This is one reason why it would be a mistake to fixate on a central bank’s actions and let them influence your investment decisions. Owning a cross-section of companies around the world through low-cost index funds remains the most sensible long-term way to deal with the stock market’s short-term uncertainties.
Has today’s post left you yearning to learn more about how money makes the world go ’round? I highly recommend two books: Pragmatic Capitalism by Cullen Roche, and Economics for Everyone by Jim Stanford. Both give clear operational descriptions of the way money works in a modern capitalist economy. Of course, you also can reach out to me, as well as tune into our weekly Rational Reminder podcasts. We’ll keep the conversation going there.
