Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Central Banks Are Losing Their Grip On Money Supply
Transcript
- Lucas: If you’ve been tracking the headlines for the last six months, you’ve probably noticed a strange disconnect. The Federal Reserve keeps the federal funds rate high, yet the usual signals of cooling demand aren’t showing up where we expect them to. It’s like turning down the heat in a room, but the thermostat is still reading hot. The reason isn’t that the data is wrong; it’s that the mechanism connecting policy rates to the real economy has shifted under our feet. Luna: Exactly. I was looking at the latest credit impulse numbers, and they’re lagging behind rate hikes by a wider margin than we’ve seen since the early nineties. It feels like the transmission belt is slipping. Lucas: That’s the right metaphor. For thirty years, the playbook was simple: raise rates, borrowing costs go up, businesses delay expansion, consumers cut back on big-ticket items, and inflation falls. But today, a significant portion of corporate debt is fixed-rate, locked in during the zero-interest era. So when the Fed raises rates, those companies don’t immediately refinance. Their cash flow doesn’t tighten. They keep hiring. They keep investing. The policy rate stops being the marginal cost of capital for a huge chunk of the economy. Luna: Right, and then you add in the fact that household savings accumulated during the pandemic are still sitting in high-yield accounts, cushioning consumption even as credit card delinquencies tick up. The buffer is thicker than the model assumes. Lucas: Let’s drill into the banking side of this, because it’s even more technical. Traditionally, central banks controlled the money supply by adjusting the quantity of reserves banks held. More reserves meant more lending. Less reserves meant contraction. But since the global financial crisis, and accelerated recently, banks hold massive amounts of excess reserves. There’s so much liquidity sitting in the system that changing the price of those reserves—the interest rate—has less impact on the quantity of lending. It’s a market flooded with water; raising the dam slightly doesn’t stop the flow if the pipes are already full. Luna: So we’re in a regime where quantity matters more than price. If the Fed wants to actually slow things down, they might have to shrink their balance sheet aggressively rather than just keeping rates high. Lucas: Precisely. And here is the concrete detail most listeners miss: the composition of who is holding that debt. A few years ago, commercial and industrial loans were driven largely by small and mid-sized banks. Now, non-bank lenders and private credit funds are taking up the slack. These entities don’t rely on deposit networks the same way. They don’t react to the federal funds rate in the same mechanical way. They price risk based on their own funding costs, which are often tied to bond markets, not interbank lending. So when the Fed moves the dial, the private credit market barely flinches. Luna: That explains why we’re seeing continued M&A activity despite high rates. Private equity firms aren’t waiting for cheap bank loans; they’re using bespoke debt structures that ignore the policy rate entirely. Lucas: You nailed it. And this brings us to the core issue for investors and policymakers: visibility. When you only watch the overnight rate, you’re watching the steering wheel while the engine is shifting gears on its own. We need to start watching the actual volume of credit extended, not just the cost of borrowing. Look at the recent quarterly reports from the major regional banks. Their loan books are stagnant, but their investment portfolios have ballooned. They aren’t lending to the real economy; they’re parking liquidity in government securities because the spread isn’t worth the risk. That’s a withdrawal of financial support, masked by stable headline rates. Luna: It’s a paradox. The central bank is trying to tighten, but banks are effectively tightening themselves by refusing to lend, even though they have the capacity to do so. The policy rate is irrelevant if the bankers are scared. Lucas: Or simply rational. With commercial real estate values softening and consumer spending showing cracks in lower-income brackets, the risk-adjusted return on new lending has plummeted. It’s not about what the Fed tells them to charge; it’s about what they’re willing to lose. This creates a situation where inflation could persist not because money is flowing too fast, but because the supply chain of credit is broken. We get sticky prices because new entrants can’t get funded to compete, so incumbents keep raising prices without fear of disruption. Luna: That’s a scary thought. Sticky inflation because the competitive pressure is missing, not because demand is overheated. So the cure isn’t higher rates; it’s restoring confidence in the lending pipeline. Lucas: I think that’s exactly right. Let’s look at one specific example to ground this. Consider the housing market. Mortgages are sensitive to long-term Treasury yields, which are influenced by the Fed, but homebuilder financing is often done through private debt facilities. Those rates have risen, but not as sharply as mortgage rates. As a result, existing homeowners are locking in low rates and staying put, reducing turnover. New construction is happening, but it’s niche and expensive. The broad market is frozen not by affordability alone, but by a lack of liquidity for the middle tier of developers. That’s a microcosm of the whole economy. Luna: It really highlights how fragmented the financial system has become. You can’t talk about 'the' interest rate anymore. There’s the retail rate, the institutional rate, the private credit rate, and they’re all telling different stories. Lucas: And that fragmentation makes the central bank’s job harder. They used to speak one language to the entire market. Now, they’re shouting in a crowded room where everyone is listening to a different speaker. The signal to noise ratio has collapsed. This is why we’re seeing more forward guidance, more qualitative statements, and less reliance on mechanical adjustments. The Fed is trying to manage expectations because the mechanical lever is jammed. Luna: But managing expectations doesn’t print goods or services. If the physical constraints on supply are still there, and credit isn’t flowing to help expand capacity, inflation stays elevated regardless of what the Chair says. Lucas: Correct. Which leads us to the practical takeaway for your portfolio. If you’re betting on a rapid disinflationary grind-down based solely on rate cuts, you might be misreading the map. The better bet is to assume a prolonged period of 'higher for longer' in certain sectors, specifically those reliant on continuous refinancing. Meanwhile, sectors that are cash-rich and debt-light, or those backed by private credit, may continue to perform well even as public markets wobble. The divergence is the opportunity. Luna: So, diversification isn’t just across asset classes anymore; it’s across funding sources. You want exposure to companies that aren’t dependent on the traditional bank lending channel. Lucas: Absolutely. And for the economists among us, keep an eye on the discount window usage and the term federal funds rate. Those are the canaries in the coal mine. If banks start relying heavily on the discount window, it means the interbank market is freezing, and the Fed’s normal tools are failing. We haven’t seen that yet, but the trend lines are moving in that direction. Luna: It’s a reminder that the plumbing always matters more than the paint. You can repaint the house, but if the pipes are leaking, the foundation rots. Lucas: Beautifully put. Before we wrap up this deep dive into the mechanics of modern monetary policy, I want to take a moment to connect this to why we’re here. Understanding these complex shifts in money supply and credit flows is exactly the kind of clarity that helps you navigate uncertainty. If walking through the economy with us has made something click, or if you’ve found value in cutting through the noise of daily headlines, consider supporting the show directly. Listener contributions are what allow us to keep this network independent, ad-free, and focused on depth over clicks. You can find us at buy me a coffee dot com slash fexingo. It’s a small gesture that keeps the lights on and the research rigorous. Luna: We really appreciate every bit of support. It lets us spend the time digging into these nuances instead of chasing viral moments. Thanks for helping us stay true to the mission. Lucas: Back to the data. One final chart to consider is the spread between commercial paper rates and Treasury bills. When that spread widens significantly, it indicates stress in short-term corporate funding. Currently, it’s relatively stable, but we’re seeing spikes every quarter-end. That seasonal stress is a warning sign that the liquidity buffer is thinner than it appears. Luna: Quarter-end squeezes. That’s where the hidden leverage reveals itself. Companies borrow to smooth their reported earnings, and when the Fed tightens, that borrowing becomes costly. Lucas: Exactly. And if those strains persist into the next fiscal year, we could see a sudden contraction in trade finance. Importers need letters of credit. If banks pull back, global trade slows. That’s a second-order effect of monetary policy that rarely makes the front page but drives recession risks. Luna: It’s the invisible hand choking the veins of commerce. Most people never see it until the shelves empty or the ships stop sailing. Lucas: Which brings us back to the beginning. The disconnect between rates and reality isn’t a glitch; it’s a feature of a maturing, complex financial system. We have to stop asking 'what should the Fed do?' and start asking 'where is the credit flowing, and why?' Luna: Because the answer to that question tells you where the pain is coming, and where the next opportunity lies. Lucas: Right. And if you’re watching the plumbing, you’ll see the storm before it hits the coast. That’s the edge we’re trying to give you here. Luna: Thanks for sticking with us through the details. It’s messy, but it’s the only way to make sense of the map. Lucas: Next week, we’ll look at how these liquidity shifts are affecting the labor market, specifically the wage-price spiral in service industries. It’s a follow-up that connects directly to today’s discussion on credit constraints. Luna: Can’t wait to dig into that. Until then, keep watching the pipes. Lucas: Stay curious, and we’ll see you on the next one.