Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Lost Control Of The Money Supply
Transcript
- Lucas: The Federal Reserve raised rates aggressively over the last three years, pushing the federal funds rate to its highest level in two decades. Yet, if you look at MZM, the measure of money that actually matters for spending, it hasn't contracted nearly as much as standard models predicted. We are seeing a decoupling between the cost of borrowing and the volume of credit created. Luna: Right, so the lever is pulled hard, but the machine keeps humming? It feels like we've hit a wall where higher rates don't stop borrowers because they aren't looking for cheaper loans anymore, they're just protecting their balance sheets. Lucas: Exactly. And that distinction is critical. In the old textbook view, central banks control the monetary base, which expands into broad money through the banking multiplier. When you raise rates, you squeeze that multiplier. But today, the multiplier is broken because banks are no longer constrained by reserves in the way they used to be. They are constrained by capital requirements and, more importantly, by the quality of loan demand. Luna: So the bottleneck isn't the availability of cheap money, it's the willingness of businesses to borrow at any price? Lucas: Precisely. Let's look at the commercial banking sector as of mid-September 2026. Small and medium-sized enterprises have been deleveraging for four consecutive quarters. They aren't taking out new loans for expansion because the return on invested capital is being crushed by input costs and labor shortages. So even though the Fed is providing ample reserves to keep the system liquid, those reserves sit idle. They don't circulate. They become dead weight on the central bank's balance sheet. Luna: That explains why we see high deposit levels but low loan growth. The money is there, but it's not moving into the real economy. It's just parking itself in savings accounts earning forty percent more interest than it did two years ago. Lucas: And that behavior changes the velocity of money entirely. Velocity is the speed at which a unit of currency is exchanged within an economy. When velocity drops, you can print all the money you want, but you won't get inflation until that money starts circulating again. Right now, we have a situation where the central bank is injecting liquidity, but the private sector is absorbing it and holding it. It's a classic liquidity trap, but driven by precautionary saving rather than deflationary panic. Luna: It’s almost ironic. The tighter the policy, the more conservative everyone becomes, which stops the very economic activity that policy was trying to cool down. So the Fed is essentially fighting a ghost. Lucas: They are fighting a structural shift in how money is created. For fifty years, we assumed that if the Fed wanted less money, they could drain reserves and force banks to lend less. But since the global financial crisis, and accelerating post-pandemic, the relationship has inverted. Now, banks create deposits when they make loans, not the other way around. If no one wants loans, the banks can't create money, no matter how many reserves the Fed stacks up. Luna: So the central bank is trying to turn off a tap that nobody is using. What happens when they finally decide to cut rates? Will that suddenly unleash a wave of borrowing? Lucas: Probably not immediately. Because the constraint isn't the price of money, it's the confidence to spend it. Businesses are sitting on cash piles recorded at record highs relative to GDP. They aren't investing because the marginal project doesn't look profitable. Lowering rates might help eventually, but it won't fix the underlying lack of productive opportunities. It's a demand-side problem masquerading as a supply-side monetary issue. Luna: This makes the 'soft landing' narrative feel even more fragile. If the tool isn't working, how do they stimulate growth without just printing money directly to consumers, which is politically toxic? Lucas: That's the dilemma. Fiscal policy has taken over the job description of monetary policy. Governments are spending directly, creating demand that the central bank can't easily dampen with interest rates. Meanwhile, the central bank is left managing the plumbing, keeping the lights on, while fiscal authorities drive the car. It's an awkward division of labor that didn't exist twenty years ago. Luna: So we have a hybrid system where fiscal policy sets the direction and monetary policy just tries to keep the engine from overheating. Is that sustainable long term? Lucas: It's unsustainable in terms of clarity. Markets hate ambiguity. When you don't know who is steering, asset prices become volatile. We saw that with bond yields fluctuating wildly last quarter. Investors are trying to guess whether the Fed will tolerate higher inflation to support fiscal spending, or whether they will tighten enough to break the government's back. Neither outcome is great. Luna: I think the biggest risk here is that we misdiagnose the problem. If the Fed thinks they just need to wait for rates to work, they might stay too tight for too long, crushing sectors that are already weak. Lucas: Agreed. There is a lag effect, but it's unpredictable. When the transmission mechanism is broken, lags stretch out. A rate hike from six months ago might only start affecting investment decisions today. That means the Fed is always reacting to yesterday's data, which makes them perpetually behind the curve. They are driving a car with a cracked windshield and a delayed GPS. Luna: Does this mean the definition of 'stable prices' needs to change? Maybe we accept higher inflation because the money supply isn't growing anyway? Lucas: That's a dangerous trade-off. If you accept higher inflation because the money supply is static, you are essentially telling workers that their wages will lose purchasing power. That creates wage-price spirals that are incredibly hard to stop. Once expectations are unanchored, the central bank loses credibility. And right now, credibility is the only asset they really have left. Luna: So they can't afford to let go. But they also can't pull hard enough to stop the pressure. It's a stalemate. Lucas: A stalemate where the status quo slowly erodes. We are seeing this in the commercial real estate market. Loans are maturing, refinancing rates are high, and borrowers are stretching themselves thin. The central bank can lower rates, but if the borrower's income stream is shrinking due to occupancy issues, the rate doesn't matter. They default regardless. That's a credit crunch, not a monetary one. Luna: So the health of the banking sector depends less on the Fed's balance sheet and more on the solvency of individual borrowers. That shifts the risk from systemic monetary failure to idiosyncratic credit loss. Lucas: Exactly. And that's harder to model. Monetary policy works on averages. Credit risk works on individuals. When the average breaks down, you get outliers. You get bank failures not because of liquidity runs, but because of bad loans that were made during the easy-money era and are now coming due in a high-rate environment. It's a legacy debt problem. Luna: It sounds like the ultimate irony: we spent twenty years building up debt, and now the cure for that debt is making it impossible to service. The medicine is killing the patient. Lucas: That's a vivid way to put it. But it highlights why the central bank is so cautious. They know they are in the middle of a delicate surgery. Cut too deep, and you kill the patient. Don't cut enough, and the infection spreads. They are waiting for a signal that the infection is gone, but the signal keeps getting noisy. Luna: What kind of signal would convince them that it's safe to pivot? A drop in CPI? Or something deeper? Lucas: They need to see a recovery in loan growth. Not just deposits sitting in banks, but actual new credit being extended to households and businesses. That's the leading indicator. If loan growth turns positive and sustained, it means confidence is returning. Until then, every rate decision is just guesswork. Luna: And until then, we're stuck in this limbo where everything looks okay on the surface, but the foundation is cracking. Lucas: It's a quiet crisis. No dramatic crashes, just a slow grind of misallocation. Capital stays in bonds instead of factories. Cash stays in vaults instead of payrolls. It's inefficiency baked into the system. Luna: Do you think regulators realize how much this has changed? Are they still thinking in terms of the 1990s framework? Lucas: Mostly yes. The institutional memory is strong, but it's outdated. They are applying analog tools to digital problems. The speed of information and capital movement has changed the dynamics completely. You can't manage a hyper-connected, instant-settlement financial system with tools designed for slower, reserve-constrained banks. Luna: So we need a new playbook. But who writes it? The Fed doesn't seem willing to admit they are lost. Lucas: Institutions rarely admit defeat publicly. They adjust quietly. Watch for changes in the composition of their balance sheet. If they start buying longer-dated assets or engaging in direct lending facilities, they are admitting the old channel is blocked. We haven't seen that yet, but the pressure is mounting. Luna: It's fascinating how invisible the breakdown is. Most people just see interest rates and assume the Fed is doing its job. Lucas: They are doing their job according to the old map. The terrain has changed. We just need to figure out where we are now. Luna: Before we go deeper into the implications for the next quarter, I want to pause for a second on something practical. Lucas: Sure thing. Luna: If walking through the economy with us has made something click, consider supporting the show directly. We don't run ads, and a small group of listeners chips in monthly through buy me a coffee dot com slash fexingo to keep these episodes going. It's literally what funds making this content possible. Lucas: Yeah, it's a modest contribution that allows us to dig into these complex topics without chasing clicks or sponsors. It helps us stay independent. Luna: If that resonates, check out the link in the description. Otherwise, let's get back to the data. Lucas: Let's look at the regional banks specifically. Since the regional banking stress test results came out earlier this month, there has been a noticeable tightening in lending standards for mid-cap companies. Luna: So the fear factor is spilling over into the middle market, not just the big corporations. That limits the pool of viable borrowers even further. Lucas: It does. And it creates a feedback loop. Fewer loans means less money creation, which means less liquidity, which makes banks even more cautious. It's a self-reinforcing cycle of contraction that interest rate cuts alone might not break. Luna: Unless the Fed intervenes directly in that market. Do you think they'll step in with credit facilities? Lucas: Maybe. But historically, they resist that because it blurs the line between monetary and fiscal policy. They prefer to let the market clear, even if it hurts. It's a principled stance that comes at a high social cost. Luna: Principles are expensive. I wonder if the political pressure will force their hand before the next election cycle. Lucas: That's the wildcard. Politics always intrudes on economics eventually. But for now, the mechanics of the money supply are playing out largely independently of Washington. Luna: It's a strange time to be a macro investor. You can't trust the usual indicators. Lucas: You have to look at the gaps. The gap between policy rates and real lending conditions. The gap between deposit growth and loan growth. Those divergences tell the real story. Luna: So the truth is in the disconnects. Lucas: Always. When the parts of the system stop talking to each other, that's where the risk lives. Luna: And we'll be watching those signals closely as we head into Q4. Lucas: We will. The question isn't just what the Fed does next, but whether the economy is listening at all.