Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Money Supply Curve
Transcript
- Lucas: So the European Central Bank has been running down its balance sheet for about two and a half years now, and as of late last year, they started to notice something interesting about how banks were reacting to the shrinking pool of reserves. Luna: Something that challenged the standard textbook model of the money supply curve, right? Lucas: Exactly. And that's what I want to talk about today — the money supply curve itself. What it is, why central banks care about it, and why the ECB's recent experience is forcing economists to rethink a few assumptions. Luna: Start with the basics. When we say 'money supply curve,' what are we actually drawing? Lucas: It's a graph where the vertical axis is the short-term interest rate — typically the policy rate, or the overnight rate — and the horizontal axis is the quantity of reserves in the banking system. The curve shows how much reserve supply is available at any given interest rate. Luna: And there are two competing versions of that curve — one vertical, one upward-sloping. Lucas: Right. The traditional textbook model, sometimes called the 'vertical money supply' view, says central banks control the money supply exogenously. They set the quantity of reserves, and the interest rate adjusts to whatever the market demands. The supply curve is vertical — perfectly inelastic to interest rates. Luna: That's the model most of us learned in macro 101. Lucas: It is. But in practice, since the 2008 financial crisis and especially after 2020, central banks have operated in a world of abundant reserves. The Fed and the ECB were paying interest on reserves, which meant they could set the policy rate directly, and the quantity of reserves was determined by their asset purchases. The supply curve looked horizontal at the policy rate — completely elastic. Luna: So two different regimes: pre-crisis vertical, post-crisis horizontal. But now we're in a third regime — balance sheet runoff. Lucas: And that's where the upward-sloping version comes in. The idea is that when reserves become scarce — when the banking system moves from abundant to ample to just enough — the relationship between quantity and price becomes nonlinear. Banks start to hoard reserves for precautionary reasons, and the marginal value of an extra dollar of reserves rises. So the supply curve becomes upward-sloping. Luna: This is the 'reserve demand curve' literature — work by people like Afonso, La Spada, and Zafar at the New York Fed. They found that as reserves fall below some threshold, the overnight rate starts to drift above the policy rate. Lucas: Exactly. And that's what the ECB saw starting in October 2025. Their balance sheet had shrunk by about 1.5 trillion euros from the peak, and suddenly the euro overnight interest rate, or EONIA, started printing a few basis points above the deposit facility rate. Luna: Which was a signal that reserves had become scarce enough that the supply curve was no longer flat. Lucas: Right. So the ECB had to recalibrate. They adjusted the terms of their long-term refinancing operations and narrowed the corridor between the deposit rate and the marginal lending rate to keep money market rates anchored. It was a real-world test of the upward-sloping curve theory. Luna: And it confirmed that the curve isn't just vertical or horizontal — it has a kink. There's a threshold level of reserves below which the curve steepens. Lucas: That threshold is sometimes called the 'scarce reserves' zone. And quantifying it is one of the big open questions in central banking right now. How many reserves does the system need before you see that upward slope? It depends on bank regulation, payment system structure, and how banks manage liquidity. Luna: The Fed has its own version of this — the 'reserve supply curve' they publish in their quarterly senior financial officer survey. They ask banks about their minimum comfortable level of reserves. Lucas: And what that survey has shown is that the aggregate minimum comfortable level — what the Fed calls the 'floor' — has been rising. In 2019, before the repo market turmoil, it was around 1.1 trillion dollars. By 2024, it had crept up to about 1.7 trillion. Banks want more buffer because of Basel III liquidity requirements and stress testing. Luna: So the supply curve is shifting outward over time. The amount of reserves that counts as 'abundant' is a moving target. Lucas: Which means central banks can't just mechanically shrink their balance sheet and assume the policy rate stays fixed. They have to monitor the slope of the supply curve in real time. Luna: And that's what the ECB did last October. They saw the curve steepening and they acted before it caused a full-blown liquidity crunch. It was a pretty textbook example of using the supply curve framework to guide policy. Lucas: It's also a reminder that the money supply curve is not a fixed law of economics — it's a function of institutional context. In a corridor system, it looks one way. In a floor system, it looks another. And during balance sheet normalization, it evolves. Luna: So if you're a bond trader or a rates strategist, you're now watching this curve very closely. The slope of the supply curve effectively tells you how much more quantitative tightening the market can absorb before overnight rates spike. Lucas: And that's directly relevant to the Fed right now. They're still running off about 70 billion dollars a month in Treasuries and mortgage-backed securities. But at the January 2026 FOMC meeting, Chair Powell said they were watching the reserve supply 'like a hawk.' Luna: Because they don't want a repeat of September 2019, when overnight repo rates spiked to 10 percent because reserves had fallen below the kink. Lucas: Exactly. That was the original stress test for the upward-sloping curve theory. And it's why the Fed now publishes a weekly 'reserve balance projections' table — basically their best guess of where the system is on the supply curve. Luna: So what new tools have they developed to manage that curve? Beyond the standing repo facility, which we covered in episode 95. Lucas: One is the 'overnight reverse repurchase agreement facility,' or ON RRP. It acts as a floor on the supply curve — absorbing excess reserves when liquidity is too abundant. By letting the ON RRP balance drain first, the Fed can shrink reserves without immediately steepening the curve. Luna: And that's exactly what happened from 2022 to 2024. The ON RRP balance fell from over 2 trillion to near zero, while reserves stayed relatively stable. Lucas: Right. That buffer bought them time. But once the ON RRP is empty — which it basically is now — every dollar of balance sheet runoff directly reduces reserves. That's when the curve starts to slope upward. Luna: And that's where we are today. The Fed is now in the 'active management' phase of the supply curve. Lucas: So the next question for central banks is: do they want to maintain a positive supply curve slope — that is, let the overnight rate drift a bit above the policy rate as a signal of scarcity — or do they want to flatten it by adjusting the rate on reserves or using repo operations? Luna: There's a philosophical debate there. Some economists argue that a slightly upward-sloping supply curve is healthy — it gives banks an incentive to manage liquidity actively. Others say it undermines the precision of policy rate control. Lucas: And this is the kind of debate that will shape the next generation of monetary policy implementation. Because the era of ultra-abundant reserves is over. We're in a new regime where the supply curve matters again. Luna: If walking through the economy with us has made something click — maybe today's deep dive into the supply curve — that's exactly the kind of content listeners tell us they value. And if it was worth a coffee to you, that's the link: buy me a coffee dot com slash fexingo. Lucas: We keep the show ad-free specifically because of that support. So if today's episode gave you a clearer picture of how central banks actually think about reserve scarcity, that's the smallest way to say it mattered. And honestly, it adds up. Luna: And we don't run ads or chase sponsorship deals. So listener support literally pays for the research time that goes into episodes like this. No pressure — just a genuine ask if you found it useful. Lucas: Alright. Back to the supply curve. One more angle I want to cover: how the slope of the curve affects the transmission of monetary policy to the real economy. Luna: Because if the overnight rate drifts above the policy rate, banks' funding costs rise, and that gets passed through to lending rates. Lucas: Exactly. So a steepening supply curve effectively tightens monetary conditions beyond what the policy rate alone suggests. It's like an automatic tightening — the market does it for the central bank. Luna: Which means the central bank could actually use the supply curve as a policy lever. By choosing how fast to shrink reserves, they can influence the slope and thereby adjust the effective stance. Lucas: That's a subtle but powerful idea. And there's a term for it: 'quantitative tightening through the supply curve channel.' The Bank of England published a staff working paper on this in early 2026. Luna: What did they find? Lucas: They estimated that a 100-basis-point steepening of the supply curve — meaning the overnight rate rises 100 basis points above the policy rate — is equivalent to about a 25-basis-point hike in the policy rate. So it's not trivial. Luna: And that's exactly the feedback loop central banks are now monitoring. If the supply curve steepens too much, they might need to slow or pause balance sheet runoff, even if inflation isn't fully tamed. Lucas: Which brings us back to the ECB's October 2025 decision. They didn't just see EONIA drifting up — they saw a 10-basis-point gap open up. That was enough to trigger a recalibration. They halted further runoff and announced a new series of targeted longer-term operations. Luna: So the supply curve isn't just an academic concept. It's a real-time policy input. Lucas: And it's one that more and more central banks are building into their models. The Bank of Japan started publishing a reserve supply curve estimate in their quarterly outlook last December. The Reserve Bank of Australia has been doing internal simulations since 2024. Luna: It's becoming a standard part of the central banking toolkit — right up there with the Phillips curve and the Taylor rule. Lucas: Which is interesting because the Phillips curve and the Taylor rule focus on the real economy — inflation and output. The supply curve is about financial conditions and the plumbing of money markets. It's a different kind of analysis. Luna: But it's equally important. Because if the plumbing breaks — like in September 2019 — the policy rate becomes disconnected from the rates that households and businesses actually face. Lucas: And that's the ultimate point. The money supply curve is the transmission mechanism's first link. If that link is broken or distorted, nothing downstream works as intended. Luna: So the next time you hear that the Fed is 'data dependent,' the data they're looking at includes the slope of the reserve supply curve. Lucas: Absolutely. And as balance sheets continue to normalize across the world, that curve will be the thing to watch. Luna: It's a good reminder that even in the most high-tech financial system, the basics of supply and demand still apply — even for the ultimate input: central bank reserves. Lucas: Yeah. And that's what makes this such a fascinating moment in monetary policy. The old rules are being rewritten in real time.