Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Lost Their Grip On Money Supply
Transcript
- Lucas: We spent the last few weeks talking about how central banks set the price of waiting, but I want to pivot to something more fundamental today: the actual volume of money floating around in the system. It turns out that for the last decade, the old playbook didn't just change; it broke. Luna: You mean the idea that if you tweak the overnight rate, you automatically control inflation? Lucas: Exactly. The standard textbook model suggests a clean transmission chain: the central bank sets a short-term rate, which influences long-term borrowing costs, which then drives investment and consumption. But looking at the data through the lens of October 08, 2026, that chain is fractured. We aren't just seeing sluggish transmission; we are seeing a complete decoupling between policy rates and the actual money supply. Luna: So the lever doesn't pull the weight anymore because the pulley system snapped? Lucas: That is a vivid way to put it. Let's get specific. In the pre-2008 era, when the Federal Reserve wanted to tighten policy, they would sell government securities from their portfolio. This drained reserves from the banking system, making cash scarce and forcing banks to bid up interest rates to borrow it. It was a physical scarcity game. Today, the system is awash in liquidity. Banks hold trillions in excess reserves. Selling bonds now barely dents that surplus. Luna: Which means the Fed can print as much as they want without immediately triggering hyperinflation, right? Lucas: Not necessarily. The issue isn't just about printing power; it's about where that money goes. When the Fed expanded its balance sheet during the pandemic, they created massive reserves. But those reserves sat in bank vaults. They didn't flow into the real economy as loans or spending. This is what economists call the collapse of the money multiplier. We used to think one dollar of base money could create ten dollars of broad money through lending cycles. Now, that multiplier is near zero. Luna: So we have a lot of money sitting still, doing nothing? Lucas: Precisely. And this creates a bizarre policy dilemma. If the money is sitting still, why did we see such high inflation recently? It wasn't because there was too much money chasing goods in the traditional sense. It was because the velocity of money spiked due to fiscal stimulus and supply shocks, while the central bank was still trying to manage rates based on old models. They were steering a ship with a rudder that no longer connected to the propeller. Luna: It sounds like they are flying blind using instruments that haven't been calibrated since the nineties. Lucas: I think 'flying blind' is generous. They have excellent visibility; they just lack control. Look at the Bank of Japan or the European Central Bank. They have been holding interest rates at or near zero for years while their balance sheets ballooned. Yet, domestic demand remained stubbornly weak. Why? Because the mechanism that turns central bank money into commercial bank credit is broken. Banks aren't lending because the regulatory capital requirements and risk assessments don't favor aggressive expansion, regardless of how cheap the funding is. Luna: So the bottleneck isn't cost; it's willingness? Lucas: It's willingness constrained by structure. Let me give you a concrete example from the US banking sector. After 2008, regulators imposed stricter capital rules, like Basel III. Banks needed to hold more high-quality liquid assets against their liabilities. So even when the Fed offered them nearly free reserves, banks chose to hoard them as safety buffers rather than lend them out to small businesses. The money supply became inert. Luna: That makes sense. Safety first, especially after the last crash. Lucas: Right. And this inertia has profound implications for us right now, in October 2026. We are seeing a world where central banks are trapped. They cannot raise rates easily because the debt levels are so high that higher financing costs would cause systemic defaults. But they cannot lower rates effectively to stimulate growth because the money isn't flowing. They are stuck in a liquidity trap where traditional tools simply do not work. Luna: Is there any tool left in the box that actually moves the needle? Lucas: There are unconventional ones, but they carry political risks. Forward guidance, where the central bank promises to keep rates low for a specific period, has limited effect when confidence is low. Then there is yield curve control, where the central bank buys bonds at specific maturities to cap long-term yields. Japan uses this. It works mechanically, but it essentially surrenders the central bank's independence to the treasury. You start monetizing government debt directly, which blurs the line between fiscal and monetary policy. Luna: Which feels dangerous. Isn't that basically printing money to pay the government's bills? Lucas: It is exactly that. And history tells us that when central banks lose their independence and start financing deficits, inflation tends to follow once the economy overheats. The problem is timing. The inflation spike we saw post-2021 was delayed because the money was stuck in the banking system. Once it finally leaked out into consumer markets, it hit all at once. That lag makes policy incredibly difficult to calibrate. Luna: So they missed the peak, and now they are trying to steer away from a cliff they didn't see coming. Lucas: A bit like that. But let's look at the current landscape. With the global economy slowing down, many investors assume central banks will cut rates aggressively to save growth. But if the money multiplier is dead, rate cuts might not stimulate borrowing. They might just inflate asset prices instead. Stocks and bonds go up, but wages and productivity stay flat. That is the inequality machine of modern monetary policy. Luna: So the rich get richer because they own the assets that rise, while the rest of us deal with stagnant wages? Lucas: That is the structural outcome. When liquidity stays in the financial system rather than the real economy, it benefits those with access to capital markets. It exacerbates wealth concentration. For the average worker, the benefit of easy money is invisible. They don't get cheaper loans for their homes or businesses because banks are too cautious. They just see higher house prices and stock valuations. Luna: It feels like the system is rigged toward stagnation rather than boom or bust. Lucas: Stagnation is actually the safer bet for policymakers, given the debt overhang. They would prefer a slow grind rather than a sudden reset. But this also means that innovation and productivity gains become even more critical. If money can't drive growth, technology has to. We are seeing central banks increasingly focus on digital currencies or stablecoins as a way to regain some control over the payment rails, bypassing the traditional banking choke point. Luna: CBDCs. Central Bank Digital Currencies. You think that solves the transmission problem? Lucas: It offers a new channel. If the central bank can send money directly to citizens' wallets, they bypass the banks entirely. This is direct monetary policy. Imagine a stimulus check that expires if not spent within thirty days. You could force velocity instantly. But the privacy concerns and the sheer logistical complexity make this a distant prospect for most Western nations. We are likely decades away from that reality. Luna: Until then, we are stuck with the broken pulley system. Lucas: For now. And that uncertainty is what keeps markets volatile. Investors are trying to price in a future where the rules of the game have fundamentally changed. They are looking for signals that the central banks have figured out a new way to transmit policy. So far, they haven't. They are mostly just managing the downside risk. Luna: Managing downside risk is a low bar for being called an economic driver. Lucas: It is. But in a high-debt, low-growth environment, survival is the primary objective. The era of aggressive fine-tuning is over. We are in an era of damage control. And for businesses, that means planning for a world where capital is abundant but cheap credit is not a reliable engine for expansion. Luna: So efficiency and cash flow management matter more than leverage? Lucas: Absolutely. Leverage was the strategy for the last twenty years. Now, operational excellence is king. You can't just borrow your way to growth anymore. You have to earn it. Luna: Interesting. It shifts the burden back to the companies themselves. Lucas: It does. And that is a healthier place to be, ultimately, even if it feels less magical than free money. Luna: If walking through the economy with us has made something click, remember that listener support is what keeps these conversations going. Lucas: We operate independently, and a couple of dollars a month helps cover the production costs without compromising our editorial voice. You can find us at buy me a coffee dot com slash fexingo. Luna: It really makes a difference in keeping the quality high and the ads away. Lucas: Thanks for considering it. Now, back to the mechanics of this broken system. Luna: Let's talk about the shadow banking sector for a second. How does all this excess liquidity affect them? Lucas: That is the perfect next step. Shadow banks don't take deposits, so they don't care about reserves in the same way. They rely on repo markets and commercial paper. When the central bank floods the system with reserves, shadow banks often sit it out or use it to arbitrage spreads. But when liquidity dries up, they face runs much faster than traditional banks. Luna: Because they don't have the FDIC safety net? Lucas: Exactly. No deposit insurance means no guaranteed liquidity. During the 2008 crisis and again in 2019, we saw repo markets freeze because lenders got scared. The Fed had to step in as lender of last resort to the shadow system. It shows that the distinction between 'bank' and 'non-bank' finance is becoming blurred in practice, even if the regulations treat them differently. Luna: So the central bank is indirectly insuring the entire financial system now? Lucas: De facto, yes. They have to ensure that the plumbing works, whether it involves regulated banks or hedge funds. This moral hazard is enormous. Private institutions take risks assuming the Fed will catch them if things fall apart. Luna: And if they know they will be caught, they might jump higher. Lucas: They certainly do. It creates a cycle of increasing risk-taking followed by emergency intervention. It is a fragile equilibrium. But understanding this dynamic is crucial for anyone investing in corporate debt or structured products. You are not just betting on the company; you are betting on the central bank's willingness to intervene. Luna: That changes the risk profile significantly. Lucas: It does. And it means that policy transparency is more important than ever. Markets need to know the red lines. If the Fed signals clearly what they will and won't do, it stabilizes expectations. Ambiguity is the enemy of efficient markets. Luna: Do you think they are getting better at signaling? Lucas: They are trying harder. The minutes and projections are more detailed now. But the underlying uncertainty about the money multiplier means that their signals are less potent. They are shouting louder into a room where the acoustics have changed. It is a constant struggle to be heard over the noise of structural shifts. Luna: Well, here is to hoping the acoustics improve soon. Lucas: To that end. Until next time.