A reflection on current Federal Reserve policy
The Fed appears to be shifting from its focus from supporting government policies to supporting commercial banking
Since the financial crisis in 2008, investors and economists have become accustomed to thinking that Federal Reserve policies being the primary contributors towards money supply growth. However, since the COVID pandemic ended, the Fed may be pursuing different policies for objectives different from what we have been used to.
When the financial crisis hit, the Fed increased the money supply in two ways: the pushed short-terms rates to almost zero, and created dollars to purchase Treasury and mortgage securities. These policies went into overdrive during COVID.
The effects of these policies can be seen clearly in the Federal Reserve’s balance sheet growth at that time.
When such greats amount of money are created, one would expect to see significant increases in consumer prices. However, during the 2010s, price increases didn’t match the magnitude of money supply growth.
That is because much of the money supply increase was used to recapitalize banks, which were severely damaged by the high-risk mortgages that defaulted in 2007 and 2008. The Federal Reserve did this by paying interest to commercial banks on excess reserve held at the Federal Reserve.
However, the price inflation picture changed during COVID. Rather than using newly-printed money to buy fixed income securities, trillions were spent on “COVID-relief efforts.” In other words, all of this money went directly into the economy. This had an immediate impact on price inflation.
Notwithstanding statements made at the time that this inflation was “transitory,” it became clear very quickly that that was simply not the case.
To quell this price inflation, the Federal Reserve raised the interest rates in the quickest manner in recent memory.
Now that the federal funds rate has declined somewhat since its peak in 2024, the yield curve for Treasury securities has begun to look more “normal” and upwardly sloping.
Meanwhile, the Federal Reserve has actually been shrinking its balance sheet, primarily by transmitting the proceeds of matured securities to the Treasury.
Interestingly, while the money supply has stagnated recently, it shows indications of resuming growth.
Which poses an interesting question: how could money supply growth continue if the Fed’s balance sheet is shrinking?
It’s because commercial banks continue to lend.
Because banks hold only a fraction of their deposits in reserve, increases in loan activity leads to increases in the money supply.
Banks make money on the “spread”: they borrow money from depositors at one rate, and lend money to borrowers at a higher rate. The greater the spread, the more they can make on each loan. (There are clearly risks arising from this model, but that is separate from this present discussion.)
Which brings us back to the yield curve.
As the yield curve moves towards normality, it normalizes the incentives commercial banks have to provide loans to customers as they’re able to make money off of the spread. If the Fed wants to support commercial banks, they’re highly incentivized to lower the federal funds effective rate even further.
It is conceivable that such commercial bank activity aligns with the goals of the Trump administration. If the administration believes that the American economy needs to rebuild its manufacturing base, it will need capital to do so. Increasing commercial bank loan activity would be a key element of this policy objective.
Nevertheless, it does appear that the Federal Reserve has shifted its policy focus from supporting the policy objectives of the federal government to supporting the business objectives of the industry for which the institution was created to support.