Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / The Death of the Money Multiplier
Transcript
- Lucas: If you studied economics before twenty-twenty, you were probably taught the money multiplier model. The idea was simple: the central bank injects a dollar of reserves, and banks multiply that into five or ten dollars of loans. It felt like a mechanical law of physics. Luna: Right. And it implied that if the Fed wanted to tighten credit, they just pulled reserves out of the system, and banks had no choice but to stop lending. Lucas: Exactly. But look at the data from today, September twenty-fourth, twenty-twenty-six. The Federal Reserve holds over four trillion dollars in reserves. That is an ocean of liquidity. Under the old model, that should have caused hyper-inflationary lending. Instead, we see steady, manageable growth. Luna: So the multiplier isn't working. Or maybe it never really worked the way textbooks claimed it did. Lucas: It’s more than that. The mechanism has fundamentally shifted. We have moved from a scarcity-based system to an abundance-based system. In the old days, banks competed for reserves because they needed them to settle payments and meet reserve requirements. Now, every major bank has more than enough reserves to sleep soundly. Luna: Does that mean the Fed lost control? Because if banks can lend whenever they want, doesn't that make inflation harder to fight? Lucas: That’s the common misconception. Control hasn’t been lost; it has been refined. The Fed doesn’t need to drain reserves to slow things down. They just raise the interest rate they pay on those reserves. If I’m a bank CEO sitting on a billion dollars in excess cash, and the Fed offers me four percent risk-free, why would I lend it out at three point eight percent to a risky business? Luna: I see. So the lever isn't the quantity of money anymore. It's the price of holding that money safely. Lucas: Precisely. This is the regime change we’re seeing in real time. The primary tool is now the Interest on Reserve Balances, or IOER. When the Fed raises that rate, they are essentially setting a floor for all other short-term interest rates. Banks won't lend below that cost, so the entire curve moves up. Luna: This changes how we think about quantitative tightening too. If they are shrinking the balance sheet, but the rate is high enough to keep banks happy, does the contraction even matter? Lucas: It matters, but differently. When the Fed sells assets or lets them mature, they reduce the total amount of reserves. But as long as those reserves stay above a certain threshold—let’s call it the comfort zone—the banking system doesn't panic. They don't rush to cut lending just because the Fed shrank its book by a few hundred billion. Luna: So there’s a buffer. A massive buffer between the current level of reserves and the point where banks actually start squeezing credit. Lucas: There is. And that buffer gives policymakers a lot of room to maneuver without causing accidental crises. In the past, if you pulled too much liquidity, overnight rates would spike, and markets would freeze. Like we saw in repo markets back in twenty-nineteen. Today, that spike risk is almost non-existent for the major institutions. Luna: But what about smaller community banks? Do they still feel the pinch of the old multiplier logic? Lucas: Smaller banks operate a bit differently. They rely more on retail deposits and local relationships. But even they are influenced by the broader pricing environment. If the Fed sets the IOER at four percent, the whole market adjusts. Small banks might not hold massive excess reserves, but they can’t offer loans cheaper than their cost of funds, which is tethered to that same policy rate. Luna: It sounds like the bottleneck has moved away from the central bank entirely. It’s no longer about whether banks lend, but whether they to. Lucas: You nailed it. The constraint is now regulatory capital and borrower quality. Banks are limited by Basel III capital requirements, not by their reserve balances. They will only lend if the return on equity exceeds their cost of capital, and if the borrower has a strong credit profile. The money supply is now demand-driven, not supply-driven. Luna: So if the economy slows and businesses stop borrowing, the money supply shrinks regardless of what the Fed does with its balance sheet? Lucas: Correct. This explains why we haven't seen explosive M-two growth lately despite massive asset purchases. The Fed provides the liquidity, but the private sector decides how much to use. If confidence is low, loans don't get written, no matter how many zeros are in the central bank’s ledger. Luna: This feels like a huge psychological shift for investors. We spent years watching the Fed's balance sheet size like a stock ticker. Lucas: It was. For a decade, headlines screamed 'Fed Shrinks Balance Sheet!' or 'Quantitative Easing Returns!'. Investors reacted violently to those numbers. But today, those headlines are largely noise. The signal is the policy rate, specifically the IOER and the overnight reverse repo facility rate. Luna: And the reverse repo facility is another key piece here, right? That’s where non-bank entities park their cash. Lucas: Yes. The Overnight Reverse Repo, or ON RRP, acts as a shock absorber. When there is too much cash in the system, money market funds sweep it into ON RRP at the Fed. This keeps those rates from falling below the policy floor. It’s a brilliant piece of plumbing that stabilizes the short-end of the yield curve. Luna: So the Fed has built a cage around short-term rates using both a floor and a ceiling, and the volume of money inside that cage is irrelevant to the daily function of the system. Lucas: That is a perfect way to put it. The volume is irrelevant as long as it stays within the cage. And right now, that cage is wide open. We have plenty of room. Luna: Does this mean monetary policy is becoming less effective? If the Fed can't force lending, can they really stimulate the economy during a recession? Lucas: They stimulate it by making money cheap enough that borrowers to take on debt. Lowering the IOER reduces the cost of funds for banks, which trickles down to mortgage rates and corporate bonds. It’s a softer touch, but it’s still powerful. It aligns incentives rather than commanding action. Luna: I guess it puts more responsibility on the fiscal side then. If monetary policy can only nudge, fiscal policy has to do the heavy lifting for structural investment. Lucas: Absolutely. We are seeing a clearer division of labor. Monetary policy manages the price of money and financial stability. Fiscal policy drives actual capital formation through infrastructure, tax credits, and government spending. Trying to use monetary policy to fix structural deficits is a mistake that leads to stagflation. Luna: Which brings us back to inflation. If the Fed is just setting prices and not controlling quantities, how do they anchor expectations? Lucas: By credibility. If markets believe the Fed will raise rates whenever inflation threatens to break above two percent, they adjust their behavior immediately. Wages and prices are set with that expectation in mind. The power lies in the threat, not the execution. Luna: So the mere possibility of raising the IOER is enough to keep companies in check? Lucas: Mostly. It’s a self-fulfilling prophecy. Companies know the Fed will act. So they moderate their own pricing. It’s elegant, though it requires constant vigilance. One misstep, one sign of weakness, and those anchored expectations can unravel quickly. Luna: We’ve seen hints of that recently. Markets are always testing the Fed to see if they’ll blink first. Lucas: They are. And in this new abundant reserves world, the Fed has to be very clear about its reaction function. Ambiguity is dangerous. When you control the price, not the quantity, clarity is your only weapon. Luna: It’s a fascinating evolution. From pulling levers to tuning dials. Much more nuanced. Lucas: Much more nuanced. And frankly, much closer to how the global economy actually functions in the digital age. The old models were built for a world of physical cash and fractional reserve scarcity. We live in a world of electronic ledgers and excess liquidity. Luna: Do you think the next generation of economists will ever teach the money multiplier again? Lucas: They might teach it as a historical artifact. Like the gold standard. Useful for understanding the past, but terrible for navigating the present. We need frameworks that reflect reality. Luna: Agreed. Reality is about rates and ratios, not multipliers and mounds of cash. Lucas: Spot on. It’s about the cost of capital in a world awash with it. Luna: Before we wrap up, I want to mention something important about how we produce these deep dives. Walking through complex monetary mechanics takes a lot of research and editing time. Lucas: We deliberately choose not to run ads on Fexingo shows. It keeps the tone consistent and respects your attention span. If you value that ad-free experience, the best way to support us is through our listener funding. Luna: Yeah, it helps us keep the lights on and the research sharp. You can find the link at buy me a coffee dot com slash fexingo. Lucas: Thank you to everyone who already contributes. It makes a real difference. Now, back to the question of the future. Luna: Right. As we look ahead, do you think the Fed will ever go back to scarcity? To draining reserves? Lucas: Unlikely. The political and market pressure to maintain that cushion is too strong. Once you build that infrastructure, you rarely tear it down. We are likely stuck in the abundance era for the foreseeable future. Luna: So we better get comfortable thinking in terms of prices, not quantities. Lucas: We do. The game has changed. The question isn't how much money is there. It's what it costs to borrow it. Luna: And whether anyone is willing to pay that price. Lucas: Exactly. That’s the real test of economic health. Not the size of the balance sheet, but the willingness to invest in tomorrow.