Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / The Central Bank Error That Broke Inflation Targeting
Transcript
- Lucas: There is a specific moment in late two thousand nine when the Federal Reserve essentially admitted that its primary tool for managing the economy was broken. They stopped talking about controlling the quantity of dollars in circulation and started focusing almost entirely on the price of those dollars, which is the interest rate. This wasn't just a tactical adjustment; it was a fundamental surrender of the traditional money supply framework. Luna: Right, because before that, the idea was that if you controlled the reserves, you controlled the lending. But once they flooded the system with liquidity, the multiplier effect vanished completely. Lucas: Exactly. The money multiplier died, or at least became irrelevant, because banks weren't lending based on how much excess reserve they held. They were lending based on risk appetite and regulatory capital constraints. So the Fed switched gears to using the federal funds rate as the sole lever to influence everything from mortgage rates to corporate bond spreads. It seemed elegant until it didn't work. Luna: And now, looking at the data through September thirty second twenty twenty six, we are seeing the long tail of that decision play out in ways nobody predicted. Lucas: The core issue is what economists call the 'transmission mechanism' of monetary policy. When the Fed raises rates to cool inflation, it should theoretically choke off credit demand. But today, that signal gets distorted by the sheer size of balance sheets and the complexity of shadow banking. The link between the policy rate and the actual cost of borrowing for a small business has become tenuous at best. Luna: So when the Fed says they are tightening, but small businesses still have access to cheap credit because of legacy debt refinancing, aren't they missing the real constraint? Lucas: That is precisely the blind spot. The Fed looks at aggregate data like the broad money supply measures, M-two or M-three, and sees stability. But if you drill down into commercial and industrial loans, you see a different story. Companies are rolling over old, low-rate debt into new contracts, masking the true pressure of higher rates. The economy isn't cooling where the Fed thinks it is; it's just shifting pain downstream. Luna: It feels like they are trying to steer a ship with a rudder that has been cut loose from the helm. Lucas: A perfect analogy. And the consequence is that policy becomes blunt. To get the desired effect on inflation, they have to push rates higher than necessary, which risks crashing asset prices unnecessarily. We saw this pattern emerge during the post-pandemic reset, but the structural change is permanent. The era of precise monetary fine-tuning is over. Luna: Do you think this error will force a return to quantity-based targets, or are they too committed to the interest rate model to back down? Lucas: They are politically locked into the interest rate model because it’s visible. Everyone understands a rate hike. Nobody really understands open market operations or reserve management anymore. So they keep hitting the same lever, hoping for a different result, while the underlying money creation process happens in the private sector, far away from their direct control. Luna: Which means the public is left guessing whether a rate hike actually means tighter money or just higher costs for existing debt. Lucas: Precisely. And that confusion creates volatility. Investors can't trust the signal. If the Fed hikes rates but the money supply keeps expanding due to fiscal spending or private credit growth, inflation persists despite the rate hikes. This is the 'stagflationary trap' that many analysts warned about five years ago. Luna: It seems like the only way out is to acknowledge that the central bank doesn't actually control the money supply anymore. Lucas: I think acknowledging that is the first step toward a more honest macroeconomic framework. Until then, we are stuck with a system that reacts to symptoms rather than causes. Luna: Before we dig deeper into the specific mechanics of this breakdown, I want to check in with you. Lucas: If walking through the economy with us has made something click, especially regarding how these complex financial systems actually impact your daily decisions, the way these stay ad-free is listener support. You can buy me a coffee dot com slash fexingo. Luna: It really helps keep the research rigorous and the explanations clear, so thank you for considering it. Lucas: Let's get back to the technical side of things, because the distortion in the transmission mechanism is even worse than I described. Luna: I remember reading about how shadow banks bypassed some of these rate sensitivities entirely. Lucas: Yes, non-bank lenders and private credit funds have grown to dominate the middle-market lending space. These entities don't rely on deposits, so they aren't directly constrained by reserve requirements or the federal funds rate in the same way traditional banks are. Their funding costs are tied to commercial paper markets and institutional investors. Luna: So when the Fed raises rates, these shadow banks might not feel the pinch immediately, allowing them to keep lending even as big banks pull back. Lucas: Exactly. This creates a divergence. Big banks tighten standards because their cost of funds rises. Shadow banks keep lending because their capital sources are sticky. This means credit remains available to risky borrowers, which fuels asset inflation without supporting productive capacity. It's a classic recipe for a bubble. Luna: That sounds like the exact opposite of what monetary policy is supposed to achieve. Lucas: It is. And the Fed is largely powerless to stop it because regulating shadow banks is a political minefield. They lack the jurisdictional authority that they once had over depository institutions. So the money supply expands in the shadows, invisible to the official statistics the Fed uses to guide policy. Luna: This makes the official inflation numbers look misleading, doesn't it? Because the velocity of that hidden money is high. Lucas: Velocity is indeed a key factor here. When money moves quickly through the private credit channels, it drives up prices of assets and services faster than the broad money supply data suggests. The Fed is watching the wrong dashboard. They are looking at the speedometer, but the engine is overheating in a compartment they can't see. Luna: So the error isn't just in the tool, it's in the entire measurement system they rely on. Lucas: Correct. The definition of money itself has fragmented. What counts as 'liquid' today includes repurchase agreements, commercial paper, and short-term repo transactions that aren't captured in standard M-two definitions. The Fed's own models are outdated because they assume a unified money supply that no longer exists. Luna: It feels like we need a complete overhaul of how we track liquidity, not just tweak the interest rates. Lucas: I agree. Without a comprehensive view of all liquidity pools, any policy decision is a guess. We are essentially flying blind, adjusting altitude based on instruments that are calibrated for a different aircraft. Luna: How does this affect regular investors trying to allocate capital in this environment? Lucas: It means you can't trust the correlation between interest rates and asset prices. Historically, when rates went up, equities went down. But recently, we've seen sectors benefit from higher rates because of the private credit boom. Investors who stick to the old playbook will underperform because the rules have changed. Luna: So diversification isn't just about geography or sector anymore, it's about understanding which parts of the credit market are insulated from Fed policy. Lucas: Exactly. You have to identify where the money is flowing regardless of the policy rate. That is where the alpha lies. The inefficiency in the market is massive because most participants are still thinking in terms of the pre-two thousand ten framework. Luna: It’s fascinating and terrifying that such a fundamental shift happened without most people noticing. Lucas: It happened quietly, in the boardrooms of non-bank lenders and the trading desks of hedge funds. By the time the broader market realizes the game has changed, the damage is often done. Luna: Do you think there is any hope for the Fed to regain credibility in this new reality? Lucas: Only if they admit their current toolkit is insufficient. Transparency about the limitations of interest rate policy would be a huge step forward. Right now, they double down on the mistake, claiming success when inflation dips temporarily, only to watch it surge again later. Luna: It’s a cycle of overcorrection and missed signals. Lucas: Yes, and it erodes trust. Every time the Fed misses its target, the market becomes less predictable. That unpredictability is the biggest tax on economic growth right now. Luna: Given that uncertainty, what is the smartest move for a business owner planning their capital structure for the next year? Lucas: Assume that interest rates will remain volatile and disconnected from the official policy stance. Lock in fixed-rate debt where possible, but also maintain relationships with private credit providers who operate outside the traditional banking system. Flexibility is the only hedge against a broken transmission mechanism. Luna: So, prepare for the unexpected liquidity flows rather than relying on the Fed to stabilize the waters. Lucas: Precisely. The water is moving in directions the Fed can't see. You need a boat that can handle rough seas in uncharted territory. Luna: That is a sobering but practical takeaway for anyone navigating the current economic landscape. Lucas: It forces us to question every assumption we hold about how money works. Once you start doubting the basics, you start seeing the cracks in the foundation. Luna: And hopefully, by seeing those cracks, we can build better strategies around them. Lucas: That is the goal. To turn confusion into clarity, one piece of data at a time. Luna: We will leave you with that thought as we wrap up this deep dive into the structural failures of modern monetary policy. Lucas: Next time, we might explore how fiscal policy is filling the void left by ineffective central banking, but for now, keep watching those liquidity pools.