Where Does Money Come From?

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 All money is lent into existence. The Federal Reserve or the government does not print money. Those two facts are vital to understanding our lead question: where does money come from? Furthermore, knowing who does and doesn’t print money and the incentives and disincentives that change the money supply are critical to inflation forecasting.  Some so-called bond vigilantes are running around like Chicken Little, warning that the Fed’s recent rate cuts will increase inflation. They fail to understand the two lead facts. Moreover, and somewhat ironic, the Fed’s shift to a dovish monetary policy has been hawkish and disinflationary on the margin.A dovish-hawkish policy description may sound crazy, but read on. With a better appreciation of how money is created, you will see that inflation fears driven by Fed actions may be misplaced. Furthermore, inflation concerns are significantly impacting bond yields. Opportunity may lay in wait for those who appreciate how the money supply impacts inflation.
 What Is Inflation?Economist Milton Friedman once stated, “Inflation is always and everywhere a monetary phenomenon.” Basically, the more money, the more inflation, and vice versa.That’s half the story. Economics 101 teaches that the changing supply of a good or service AND the demand for said good or service determines price changes.Demand is a function of the amount of money and credit in the financial system. Furthermore, it’s not just about the amount of money in the system, as Friedman alludes, but the desire to spend it.Left out of Friedman’s infamous quote, supply is equally important to the inflation equation. Supply is the amount of goods or services being offered for consumption.This article focuses on the creation of money and its role in generating inflation.
 Banks Print MoneyWe will talk about the Fed and the government’s influence on the money supply, but as we led, all money is lent into existence. Thus, lenders, i.e., banks and other financial institutions, not the Fed or government, directly control the money supply.The US financial system and almost all other nations use fractional reserve banking systems. Below, we share a simplified example of how banks create money.You deposit $1,000 into a savings account at a bank. The bank holds 10%, or $100, in reserves in case some customers want to withdraw money. It then lends the remaining $900. The borrower of the $900 buys a ring from a jeweler with the loan. The jeweler then deposits $900 at the bank. You have $1,000 on deposit, and the jeweler has $900. In the flash of an eye, the money supply rose to $1,900. $900, in this example, was lent into existence. The bank may then lend out $810 of the jeweler’s $900, keeping $90 on reserve. The process continues, turning the initial $1,000 into nearly $9,000, assuming the bank holds 10% in reserve.  As illustrated in the example, the money supply changes based on the banking system’s willingness and ability to lend money and consumers’ demand and ability to borrow it. Further, as we will discuss, the amount of reserves is critical.
 The Fed’s Role In Printing MoneyAs we noted, the Fed does not print money. Nor do they have any control over the supply of goods and services. Yet, despite having no direct control over supply or demand, one of the Fed’s two Congressional mandates is to “maintain price stability.” Per the St. Louis Federal Reserve:Price stability means that inflation remains low and stable over the longer run.The Fed doesn’t directly control the supply or demand of goods, services, or money. However, they can significantly influence the supply and demand of money and the demand for goods and services. They do this in many ways.
 Interest Rate PolicyInterest rate policy is the Fed’s most followed tool. Borrowers are more inclined to borrow when rates are lower rather than higher. Thus, interest rate policy indirectly influences loan demand, which, as noted above, directly influences the money supply and demand for goods and services.The problem facing the Fed with managing interest rates is that they only manage the overnight Fed Funds rate. They do not set mortgage, automobile, or corporate borrowing rates. Those rates drive the creation or contraction of money and demand for goods and services.
 RegulatoryThey can use their regulatory prowess to influence the entire array of interest rates and loan types. Of note is its management of banking reserves and capital requirements. As we shared in our example, reserves are the fodder for money creation. If a bank increases its reserves, it must de facto lend less and vice versa. While the Fed no longer mandates specific reserve requirements, they influence bank decision-making regarding reserves. Capital requirements work similarly. When the Fed requires more capital for bank assets, the banks’ ability to lend is lessened. Conversely, easing capital requirements makes lending more profitable.Since 2008, the Fed has relied on QE and QT to add or reduce reserves from the banking system. QE entails purchasing bonds from banks; in exchange, the banks receive reserves. Thus, QE boosts reserves, which facilitates lending. QT works the opposite way.
 Wealth EffectLastly, there is the wealth effect. Ben Bernanke summed this tool up well.Fed ToolsThe Fed tries to slow or increase borrowing and economic activity by managing interest rates, reserve and capital rules, and financial conditions. Its policies can impact the supply and demand of money. Additionally, as economic growth gyrates with Fed actions, the supply and demand for goods and services will change. While they do not print money, their tools can incentivize its printing. Importantly, they give the Fed some ability to manage inflation.
 Uncle Sam Doesn’t Print MoneyThe US Treasury runs the nation’s mints. Those mints print money. However, they do not print new money, per se. The only way the government creates new money is when it borrows. Remember, all money is lent into existence. Thus, when the Treasury issues a bond, new money is created.Unlike the traditional spending habits of the government, during the pandemic, they borrowed and wrote checks to individuals and companies. In 2020 and 2021, the Federal government borrowed over $6 trillion. By doing so, they significantly increased the money supply. However, new money is inflationary only if the money is spent. Printing a zillion dollars and burying it in a hole should not affect prices.The money was spent. Furthermore, the supply of goods and services was deeply curtailed due to the pandemic. The combination of more money and lesser supply spelled inflation.It is fair to say the government prints money via debt issuance, but it is not from a printing press, as most people believe.
 The Fed Rate Cuts Are Disinflationary, So FarIronically, the current rate-cutting cycle is marginally reducing inflation. This is the hawkish-dovish monetary policy we allude to at the opening.Interest rates across the curve increased by nearly 1% after the Fed started cutting rates. Accordingly, all types of loans became more expensive, thus reducing the incentive for individuals and corporations to borrow. Less money on the margin is being lent into existence.As government borrowing interest rates rise, government deficits follow. As we share below, the federal interest expense has doubled in just a few years. It now comprises 15% of all government expenditure, up from a low of 5% when interest rates were at record lows four years ago. More government borrowing equals more money supply, which can be inflationary.However, President Trump has prioritized deficit reduction partly due to the impact of higher interest rates. Less government spending will reduce the growth of the money supply. Additionally, it will negatively impact the economy in the short run, which should be disinflationary on the margin.Lastly, it’s worth noting that the Fed’s QT program is still ongoing, albeit at a reduced pace. As we said, QT removes reserves from the banking system, thus making lending less likely on the margin.
 SummaryBanks and borrowers determine the money supply. The Federal Reserve tries to steer the incentives of banks and borrowers with short-term rates, reserves, capital restrictions, financial conditions, and their aggregate economic impact. While they have no direct control over the supply of goods and services, they have enough economic sway to affect the supply side.As we saw with the pandemic, the government can also indirectly increase the money supply. When the borrowed money flows rapidly into the economy, demand can outstrip supply, resulting in inflation. However, when deficits are tame, the government is not likely to create inflation. While a story for a different day, government debt can generate inflation in the short run if it creates a mismatch with supply. However, in the long term, the unproductive nature of the debt results in weaker economic growth and disinflation. This is a significant long-term headwind for the US economy.More By This Author:Meme Coins Do Not Create Wealth: They Destroy It
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