How the Fed Works

November 24, 2008
by Jake, the Champion of the Constitution

In this article, I hope to share, as simply as possible, enough details for you to understand how modern-day central banking tries to control the money supply, and even how the value of the paper money in your wallet or the electrons in your bank account fluctuates on a daily basis. First I will formally define fractional reserve banking and describe how it expands or contracts the money supply. Next I will share how the Federal Reserve controls monetary policy and supply with its three major tools – “printing” or “de-printing” money (technically referred to as “open market operations” by the FED), bank reserve requirement ratios, and the infamous “Fed-rate.”

Fractional Reserve Banking is a banking system in which banks are supposed to maintain a quantity of reserves from their depositors.  This quantity is a fixed fraction of the amount of new money the banks are then allowed to create.  This newly created money is then loaned to the bank’s borrowers.

Fractional reserve banking has two major flaws.  The first is that money creation is a fraudulent or even criminal act, which is a topic more suited for Part 7.  (See Rothbard’s “The Case Against the Fed” below, pages 40-45.)

The second flaw is insolvency.  This is commonly known as a “bank run” and is easy enough to understand.  If the system’s depositors demand in excess of the reserve amount within a short enough time span, the entire system theoretically just runs out of printed cash and goes broke. To prevent this system crash, governments often resort to a massive physical printing of currency, resulting in massive devaluation of the currency and its eventual demise by hyperinflation.  Hyperinflation in its terminal stages looks like Zimbabwe’s, which is estimated at 89.7 sextillion percent.

Here is how fractional reserve banking works in the United States, using the current approximate 10% fractional reserve ratio requirement:

1) A depositor deposits $100 with a bank.  (This depositor could be a citizen, or another bank, even a receiver of the FED’s open market operations which is described later.)

Total Reserves: $100, Total Loans: $0, Total Money Supply: $100

2) The bank holds $10 for its reserves and loans out the other $90 to other banks or citizens.  If it is a citizen, this money is temporarily held outside the banking system until he/she decides to deposit the money into a bank.

Total Reserves: $10, Total Loans: $90, Total Money Supply: $100

3) Next, the second bank takes the $90 in deposits, holds $9 for its reserves, and loans out the other $81.

Total Reserves: $19, Total Loans: $171, Total Money Supply: $190

4) Step 3 repeats.  The third bank takes the $81 as a deposit, holds $8.10 for its reserves, and then loans out $72.90.

Total Reserves: $27.10, Total Loans: $243.90, Total Money Supply: $271

5) Step 3 repeats again.  The fourth bank takes the $72.90 as a deposit, holds $7.29 for its reserves, and then loans out $65.61.

Total Reserves: $34.39, Total Loans: $309.51, Total Money Supply: $343.90

6) And so on.  The bulk of the money creation is done after 15 repeats, but what is eventually left after 40 or 50 repeats is pretty much:

Total Reserves: $100, Total Loans: $900, Total Money Supply: $1000

So you can see that within a very short period of time, banks transferring to other banks within the system can CREATE $900 from the initial $100 deposit.  For many, this process is such NONSENSE that it is indeed hard to grasp, which is why I used the numbered steps and tallies. 

Now I will describe how the FED controls our monetary policy in concert with the fractional reserve banking system.  The FED uses three prime monetary mechanisms to accomplish this. These powers are Open Market Operations, Bank Reserve Requirement Ratios, and the Discount Rate.   I will not discuss the FED’s vocal propaganda pronouncements which have had some success at driving contemporary and future expectations in the past.

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The FED’s Open Market Operations are the “principle tool for implementing monetary policy,” which is fancy for saying they are the FED’s best way to swell or contract the money supply.

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The Federal Reserve writes here on page 36 (my italics) “In theory, the Federal Reserve could conduct open market operations by purchasing or selling any type of asset. In practice, however, most assets cannot be traded readily enough to accommodate open market operations. For open market operations to work effectively, the Federal Reserve must be able to buy and sell quickly, at its own convenience, in whatever volume may be needed to keep the federal funds rate at the target level. These conditions require that the instrument it buys or sells be traded in a broad, highly active market that can accommodate the transactions with­out distortions or disruptions to the market itself.”

Earlier this year and for decades prior, the vast amount (as in 90-95%), of the FED’s balance sheet rested in US Treasury securities traded in New York City.  However, this changed with the Great Panic of 2007, and the FED is now exercising its’ once-theoretical abilities.   The Atlanta FED published this truncated graph, and now foreign securities, AIG, illiquid mortgage debt have replaced, then ballooned the FED’s balance sheet.  Now Treasury securities account for only 32% of the FED’s balance sheet, which limits the effectiveness of this monetary weapon, per the FED’s own admission above.

Here’s how it works, step-by-step, when the FED buys Treasuries, although it is the same process for whatever asset they wish to purchase.

1) The FED’s Open Market Committee (FOMC) decides expand the nation’s money supply and purchases, for example, $10 billion in Treasury bonds.

Monetary Supply Expansion: $0

2) The FED writes a check on itself for $10 billion.  [Where did it get the money?  The answer is FROM NOWHERE!]

Monetary Supply Expansion: $10 billion

3) This $10 billion FED check then goes to one of the select government bond dealers (such as Secretary Paulson’s Goldman Sachs) in exchange for the $10 billion in Treasuries.

Monetary Supply Expansion: $10 billion

4) Then the bond dealer deposits its $10 billion FED check at a commercial bank.

Monetary Supply Expansion: $10 billion

5) Go to the fractional reserve loop above.  We just learned how this deposit will very quickly be “pyramided” and lead to $10 billion in deposits and $90 billion in loans within the banking system.

Monetary Supply Expansion: $100 billion

Now, the FED can very quickly CONTRACT the money supply in a similar fashion by SELLING its assets.  The process typically takes several weeks.  However, the key enabler to do this is that there must be a buyer outside of the FED so it is not quite as easy – Treasuries are (historically-speaking) a liquid market, but the AIG debt, for instance, is a lot harder to find a buyer for.

[And yes, the US government DOES pay interest on the Treasuries to the FED, which many harp on, since it can never be paid back since there are not enough dollars in the banking system to ever clear all of the debt owed.  Others love to point out that the privately-held FED stock pays a guaranteed 6% annual dividend to the (undisclosed) owners.   However, if these are compared to the raw power to create money with its open market operations and the power I will describe next, I want to point out that these are, monetarily-speaking, quite insignificant.]

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The FED’s control over bank reserve requirements is an incredibly powerful backup punch to its’ open market operations power. 

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Per the FED, the reserve requirement ratio is the ratio of “funds that a depository institution must hold in reserve against specified deposit liabilities.”  “Specified deposit liabilities” are traditionally limited to cash deposits from depositor, but the FED is technically free to redefine this as they wish.  A simpler, but slightly less precise, definition is  the fraction of deposits at a bank that it is supposed to hold in cash for withdrawals.  I write “supposed to” since modern banks do not really have to do so.  (Like the thieving medieval goldsmith, good work if you can get it!)

The Federal Reserve writes here on page 41 (my italics): “The Federal Reserve can adjust reserve require­ments by changing required reserve ratios, the liabilities to which the ratios apply, or both. Changes in reserve requirements can have profound effects on the money stock and on the cost to banks of extending credit and are also costly to administer; therefore, reserve requirements are not adjusted frequently. Nonetheless, reserve requirements play a useful role in the con­duct of open market operations by helping to ensure a predictable demand for Federal Reserve balances and thus enhancing the Federal Reserve’s control over the federal funds rate.”

“Profound effects” is right!  The reserve requirement ratio has been more or less at 10% since the 1990s, falling from 14% in the 1970s.  Rothbard notes: “Ever since the Fed, after having expanded bank reserves in the 1930s, panicked at the inflationary potential and doubled the minimum reserve requirements to 20 percent in 1938, sending the economy into a tailspin of credit liquidation, the Fed has been very cautious about the degree of its changes in bank reserve requirements.” (p. 144)

However, if the Federal Reserve Board of Governors have a  joint bad hair day and decide tomorrow to halve the reserve requirement ratio to 5%, the nation’s money supply will almost DOUBLE in a matter of weeks.  A $20,000 asset like a car or a small apartment would rapidly approach $40,000 in value.  In fact, just about everything would see 100% inflation, but salaries’ purchasing power would be halved until the inflationary tidal wave rips them upwards.  (The FED finds it far less painless to do this over a long period of time by utilizing open market operations.  What I just described happened not in a few weeks, but from 1985 to 2008.  Use this calculator for those years to track the worth of $1.)

With the weapons of “open market operations” and “reserve ratio requirements,” the FED has close to absolute monetary control over the American dollar, aka the Federal Reserve Note.  There is one last tool that is more or less a propaganda-type revolver, although without bullets recently.  However, since it is what most Americans associated with the FED before the Great Panic of 2007, I will address it briefly.

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The FED Discount Rate, or “Fed Rate,” is the interest rate the FED charges to banks to borrow from the FED.  However, borrowed reserves are not as satisfactory to the banks as reserves that are wholly theirs, as they now have to pay it back with interest.

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Per the FED, the discount rate “is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility – the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.”

However, the Federal Reserve also notes “the volume of discount window borrowing is rela­tively small.”  Besides being famous previously for dramatically shifting the stock market’s ebb and flow within minutes of its announcement, it is merely an ordinary wave in monetary policy compared with the other two powers.  An open market operation could be construed as a double-overhead (surfer slang), and a sizeable shift in the reserve requirement ratio could be construed as a monster rogue at a certain magical place in California called Maverick’s.