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How The Federal Reserve Reduces the Money Supply

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EDITOR NOTE: The Federal Reserve says it’s not reducing the money supply as a hedge against inflation. However, recent actions show the opposite. These actions aren’t ones that directly reduces the money supply, but that do it indirectly. The Fed’s recent sale of a trillion dollars of reverse repos reduced bank reserves, which, in turn, will reduce banks’ lending money. When the lending slows, the overall money supply in the economy goes down as well. This is a sly way of reducing the money supply without doing so overtly and raising alarm bells. The timing of this is also interesting as we get ever closer to September 30, when the IMF revalues their global SDR basket, which could devalue the U.S. dollar substantially if it’s knocked from its perch as the world’s reserve currency. 

In their Aug 6. letter in response to our op-ed “How the Fed Is Hedging Its Inflation Bet” (Aug. 2), John Greenwood and Steve Hanke argue that the Fed’s sale of a trillion dollars of reverse repos does not in and of itself reduce the deposit liabilities of banks and money-market mutual funds, and that the money supply is unaffected. By that logic, none of the monetary tools of the Federal Reserve Bank would affect the money supply.

Raising the reserve requirement, selling securities in the open market and raising the interest paid on reserves may not directly change the money supply, but they reduce bank reserves, which reduces bank lending and therefore reduces the money supply. Of course, if the buyer of a reverse repo or a security sold by the Fed is a nonbank and pays for the purchase using its bank account, the money supply is directly affected.

Prior to the sale of a trillion dollars of reverse repos, the banking system was holding reserves in response to its evaluation of market conditions, regulatory requirements and the interest paid on reserves. When the Fed sold the reverse repos and the purchasers paid the Fed, bank reserves were reduced, just as they would have been had the Fed sold government securities in the open market. Actions reducing reserves tend in turn to induce banks to reduce lending.

We never wrote that the reduction in bank reserves directly reduced money supply growth. We wrote that in response to the reduction of bank reserves, “not surprisingly, money supply growth is starting to moderate.” The point is that the Federal Reserve is taking action to reduce potential future money growth. In effect, it’s “hedging its inflation bet.”

Original post from WSJ

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