Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Lose Control Of Money Supply
Transcript
- Lucas: Look, if you’ve been tracking the macro news cycle lately, there’s a weird dissonance happening right now. The Federal Reserve’s balance sheet is still massive compared to pre-pandemic levels, yet the usual panic about excess money supply driving hyperinflation hasn’t materialized in the way people expected. It feels like we’re watching a ghost story play out, but the mechanics are actually very real. Luna: Right, because the old playbook said more reserves mean more lending and higher prices. But that link seems broken. What’s actually holding the money back? Lucas: It’s not that the link is broken; it’s that the entire architecture of how we think about money has flipped. For decades, central banks operated under a scarce reserves regime. They viewed reserves as the fuel for the engine. If they wanted to stimulate the economy, they injected reserves, which banks would then lend out, creating credit. But today, we are firmly in an ample reserves regime, and that changes everything about how policy works. Luna: So instead of treating reserves as a scarce commodity to be rationed, they’re just treating them as a baseline infrastructure cost? Lucas: Exactly. Think of it like the electrical grid. You don’t turn off the power to every house because one person decides not to use their AC unit. In the old days, the Fed had to carefully meter out reserves to keep the lights on. Now, there is so much liquidity in the system that the marginal dollar of reserve doesn’t trigger a new loan. It just sits there. And that distinction is critical for understanding why our current inflation data looks the way it does in October 2026. Luna: But if reserves aren’t forcing loans, why do we still worry about the Fed printing money? Isn’t that just semantic hair-splitting? Lucas: It’s not semantics, it’s about transmission mechanisms. Under the scarce reserves model, the Fed controlled the price of money by manipulating the quantity. They’d drain reserves to push rates up. Now, with trillions in excess reserves, draining them barely moves the needle. So they switched tactics. They stopped trying to control the quantity of reserves and started using interest on reserves to set the price directly. It’s a complete inversion of the Monetarist logic that dominated the eighties and nineties. Luna: So the lever they pull isn’t the size of the balance sheet anymore, but the rate they pay on those idle balances? Lucas: Precisely. Let’s talk about the specific mechanism: Interest on Reserve Balances, or IORB. When the Fed raises that rate, commercial banks immediately adjust their lending behavior to stay competitive. If the Fed pays four percent on reserves, a bank isn’t going to lend to a risky borrower at three point five percent. They’ll just park the money. It’s a cleaner, more direct signal than the chaotic open market operations of the past. Luna: That sounds efficient, but doesn’t it create a distortion? Like, why lend to the real economy when the government pays you risk-free? Lucas: That’s the exact tension we’re seeing. It creates a 'carry trade' mentality within the banking sector. Banks prefer safe, liquid assets over credit risk when the spread is tight. This explains why we haven’t seen the explosive credit growth some analysts feared after the 2020 asset purchases. The money didn’t vanish; it just got stuck in the financial system’s plumbing rather than flowing into main street commerce. Luna: So the money supply metrics like M2 are misleading because they count things that aren’t really circulating as purchasing power? Lucas: Yes, and that’s why looking at M2 growth in isolation is dangerous. M2 measures the potential for spending, not the actual velocity of spending. If those dollars are sitting in bank reserves earning forty basis points above zero, they aren’t chasing houses or cars. They are waiting. The velocity component has collapsed, which decouples the money supply from the price level. Luna: It’s almost like the central bank accidentally created a savings account for the entire banking sector that nobody wants to touch. Lucas: A perfect analogy. And here is the tricky part for investors: if the Fed wants to tighten policy now, they can’t just sell bonds and hope to drain enough reserves to make rates spike. They have to raise the IORB rate aggressively. Because if there is too much liquidity, the only way to get banks to tighten their lending standards is to make holding those reserves more expensive relative to other short-term instruments. Luna: Does that mean the bond market is actually less important than the repo market for steering the economy now? Lucas: The repo market has become the primary transmission channel. Specifically, the Overnight Reverse Repo facility, or ON RRP. That’s where non-bank institutions like money market funds park their cash overnight with the Fed. When ON RRP usage is high, it acts as a shock absorber. It sucks excess liquidity out of the private sector and puts it in the Fed’s vault, effectively neutralizing it without the Fed having to do anything active. Luna: So the ON RRP is like a pressure valve that prevents the system from overheating when there’s too much cash sloshing around? Lucas: Exactly. And as we move through Q4 2026, we’re watching that valve drain. As Treasury issuance continues and corporate cash piles sit in these funds, the ON RRP balance is slowly declining. Once it hits zero, the Fed loses that buffer. Then, any additional liquidity injection or shortage will hit the banking system directly, making rate control much harder. Luna: That sounds like a ticking clock. If the buffer disappears, does the Fed lose its grip on stability? Lucas: Not lose its grip, but lose its margin for error. Right now, they have room to maneuver because of that massive pool of parked cash. Once it’s gone, they have to rely entirely on interest rate adjustments, which are blunt tools. It’s the difference between using a dimmer switch and a light switch. We’re currently using the dimmer, but the battery is running low. Luna: This makes me wonder about the global context. Are other central banks facing the same ample reserves problem? Lucas: Mostly. The ECB and the Bank of Japan have different structures, but the trend is universal. Post-2008, nearly every major central bank expanded its balance sheet dramatically. The Bank of England is still navigating the aftermath of its gilt market crisis, which was essentially a liquidity trap in reverse. They tried to buy bonds without providing enough collateral, and the system seized up. It was a stark reminder that liquidity is fragile. Luna: So even with all this money, the system is surprisingly brittle if you pull the wrong lever? Lucas: Brittle in specific places. The shadow banking sector relies on stable funding. When the Fed manages reserves poorly, that funding dries up instantly. That’s why the focus has shifted from just 'how much money is there' to 'who holds it and where is it parked.' It’s a structural question, not just a quantitative one. Luna: I love that distinction. Structural versus quantitative. It changes how you read the daily headlines. Lucas: It does. And it brings us to the donation segment. We deliberately don't run ads on these. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. Luna: We appreciate the support. It keeps us independent and focused on the deep dives you actually care about. Lucas: Thanks for listening. If walking through the economy with us has made something click, your support helps us keep digging into the plumbing. Luna: Yeah, it really does. Back to the topic. Lucas: Let’s circle back to the implication for your portfolio. If the money supply isn’t driving inflation directly, what is? It’s mostly wage growth and service sector pricing. The goods deflation we saw post-pandemic is reversing slightly, but it’s not because of excess liquidity. It’s because of sticky labor costs. Luna: So the inflation fight isn’t about draining the reservoir, it’s about cooling the demand side directly? Lucas: Correct. Higher interest rates hurt borrowers, not lenders. Since lenders are already happy parking cash at the Fed, raising rates doesn’t stop them from holding reserves. It stops companies from taking out new loans to expand capacity. It’s a slower, more painful brake than everyone hoped for. Luna: That sounds like a slow bleed rather than a sudden crash. Is that good for stability? Lucas: It’s better than a crash, but it’s terrible for growth. It means we’re likely heading toward a period of stagnant nominal GDP. Not a recession, necessarily, but a lack of upward mobility in income and asset prices. The abundant liquidity is being absorbed by debt service rather than new investment. Luna: So the central bank is effectively taxing borrowers to subsidize savers, which suppresses overall activity? Lucas: That’s a fair way to put it. It’s a wealth transfer from borrowers to depositors. And since most deposits are held by wealthier individuals, it exacerbates inequality while trying to control inflation. It’s a policy trade-off that politicians rarely discuss openly. Luna: Because it’s unpalatable. Nobody likes hearing that their tax dollar is helping someone else earn risk-free returns. Lucas: Exactly. And it highlights why the Fed is so hesitant to cut rates prematurely. If they cut too soon, they might reignite the very inflationary pressures they’re trying to dampen, but through a different channel. They’re playing whack a mole with two different types of inflation drivers. Luna: It feels like they’re walking a tightrope without a net. Lucas: They are. And the tighter the ample reserves regime gets as the ON RRP drains, the narrower that tightrope becomes. We’re entering a phase where precision matters more than scale. Luna: So the next big move won’t be a giant QE announcement, but a subtle tweak to the IORB rate? Lucas: Most likely. The era of loud, dramatic balance sheet expansions is over. The future of monetary policy is quiet, technical, and driven by interest rates alone. It’s less visible, but arguably more powerful. Luna: It’s fascinating how invisible the machinery has become. You used to see the trains; now you just feel the vibration. Lucas: That’s the best way to describe it. The trains are still moving, but the tracks have been rerouted underground. Our job is just to figure out where the exit is. Luna: I guess we’ll have to keep watching the plumbing closely. Thanks for breaking that down. Lucas: Anytime. Keep asking the hard questions about how the system actually works.