Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Can No Longer Control Money Supply
Transcript
- Lucas: The Federal Reserve has effectively admitted that it no longer controls the volume of money in the economy, only its price. This is a fundamental departure from every textbook you studied, and it explains why inflation feels so sticky right now despite aggressive tightening. Luna: I remember when we were taught that raising rates would shrink the money supply through the credit channel. That mechanism seems completely dormant today. Lucas: It’s dormant because the plumbing changed. Since the global financial crisis, and accelerated by the pandemic response, we’ve moved into an era of abundant reserves. The Fed doesn’t need to auction reserves anymore; they just flood the system and pay banks to hold them. Luna: So instead of scarcity driving behavior, abundance is doing the work. That sounds like a lot of power sitting idle in bank vaults. Lucas: Exactly. And that leads us to the donation part of the show. If walking through the economy with us has made something click about how these mechanics actually impact your wallet, the way these stay ad-free is listener support — buy me a coffee dot com slash fexingo. Luna: It really helps keep the deep dives possible. Thanks for listening, and thanks for supporting the show. Lucas: Let’s get back to the core issue: Interest on Reserves. When the Fed pays banks more to keep cash at the Fed than they can lend it out in the market, they create a floor. But they also cap the ceiling. Luna: Right, so banks have zero incentive to lend excess reserves if they’re guaranteed a better return sitting still. It’s a safety trap. Lucas: Precisely. And this breaks the link between base money and broad money. You can print as much base money as you want, but if banks aren’t lending it out, M2 doesn’t expand. That’s why we saw M2 contract while the Fed balance sheet stayed huge during the normalization phase. Luna: That’s counterintuitive for most investors. They see the balance sheet and assume inflation is coming, but the velocity is dead. Lucas: Velocity is indeed dead. But here is the twist that keeps policymakers up at night: what happens when demand returns? When those reserves start flowing out? Luna: If all those trillions of dollars decide to move at once, could we get a sudden spike in inflation that no one sees coming? Lucas: That is the specific risk we are tracking in September 2026. The Fed has been trying to drain reserves slowly, but the pipeline is clogged. They are using the Overnight Reverse Repo facility to soak up excess liquidity from money markets. Luna: So they are paying hedge funds and money market funds to park cash at the Fed overnight. It’s like renting out empty seats on a plane. Lucas: Perfect analogy. And it works well until it doesn’t. Once the reverse repo balance drops too low, the Fed loses its ability to control short-term rates. They will be forced to inject reserves again, potentially reigniting asset bubbles. Luna: So they are playing a balancing act between deflationary pressure and reflationary risk, with no clear signals from the data. Lucas: Correct. And this is why standard models fail. Most economists look at GDP growth and employment to predict rate cuts. They ignore the state of the banking system's balance sheet entirely. Luna: It’s like diagnosing a patient by looking at their face but ignoring their heart rate monitor. The vital sign is right there in the reserve accounts. Lucas: A great point. Let’s talk about the SOFR benchmark. Since the Fed shifted to administering rates rather than trading bonds, SOFR has become the key indicator. But it’s noisy. Luna: Noisy because it reflects the margin of individual banks, not necessarily the systemic cost of capital. Some banks are desperate for liquidity, others are swimming in it. Lucas: Exactly. That dispersion creates volatility. In March 2023, we saw SVB collapse partly because regional banks were undercapitalized and couldn’t access this reserve pool easily. The system wasn’t liquid for everyone, even though it was liquid for the big players. Luna: So the 'plumbing' is fragmented. The big banks are fine, but the mid-sized lenders are starved. That distorts credit availability for small businesses. Lucas: Which feeds back into the real economy. When credit dries up for SMBs, hiring slows. But the headline unemployment number might not reflect that lag yet. We are seeing that lag play out now. Luna: It feels like we are managing the aftermath of two decades of unconventional policy, rather than setting policy for the future. Lucas: That is a very sharp observation. We are living in a post-quantitative easing world where the tools we inherited don't quite fit the problems we face. The Fed is essentially steering with a rudder that’s too large for the current water conditions. Luna: Do you think they will ever go back to scarce reserves? Or is abundant reserves the new normal? Lucas: I doubt they will fully revert. The friction of going back is too high. Instead, they will likely continue to use administered rates to manage the system, accepting that they have less control over the total volume of credit. Luna: So we should stop watching M2 growth as a leading indicator for inflation. What should we watch instead? Lucas: Watch the spread between the federal funds rate and SOFR, and monitor the reverse repo balance closely. If reverse repo hits zero and the spread widens, the Fed is losing control of the floor. Luna: That’s a concrete signal. So if I see reverse repo drying up, I should prepare for potential market volatility regardless of what the Fed says. Lucas: Yes. Because when they lose control of the floor, they have to hike rates aggressively to bring borrowing costs down, which shocks the economy. It’s a binary outcome. Luna: Binary outcomes are never fun for investors. It feels like we are waiting for the other shoe to drop. Lucas: We are. And the irony is that the same tools that stabilized the system in 2008 and 2020 are now making it harder to normalize. We traded precision for stability, and now we are paying the price for that trade-off. Luna: Stability bought with ambiguity. That’s a costly lesson, but a necessary one for the next generation of monetary policy. Lucas: Absolutely. As we wrap up, I’m curious if you think the Fed will admit this loss of control publicly, or if they’ll continue to speak in terms of 'normalizing' when the system is fundamentally different. Luna: They’ll probably keep speaking in normal terms. Admitting the paradigm shift would shake confidence. Better to pretend the old maps still work. Lucas: Maybe. But the markets are starting to price in the reality that the plumbing matters more than the rhetoric. Keep an eye on the reserve balances, and let’s see where the water flows next.