How can the Fed Destroy Money It Created?

March 19, 2009 7:41 AM

[MonetaryPolicyFilter] In relation to the Fed's huge injection of money yesterday, please explain to me how, if at all, the Federal Reserve can destroy money on its balance sheet in a way that offsets the inflation that normally would result.

The Fed's announcement yesterday that is it going to flood the economy with dollars would, in normal circumstances, be horrifically inflationary. But these are not normal normal circumstances. My questions are:

1) Why isn't this inflationary? To what extent have deflationary factors stemming from the credit crisis not yet worked their way into the economy such that they will offset what inflation results?

2) Explain Federal Reserve accounting to me. I sort of understand that the Fed can create this $1 trillion from basically thin air, but can it destroy money just as easily as it creates it?

3) Because the Fed is buying debt and debt-related instruments, can the Fed take the principal and interest payments it receives from these debtors (e.g. the U.S Treasury), and destroy that money just as easily as it created that money? In other words, when Treasury makes interest payments to the Fed on the bonds the Fed bought, can the Fed simply take that money and strike or "disappear" it from it's balance sheet forever?

4) If the Fed can do what is described in (3), is that the mechanism the Fed intends to use to avoid inflation that would normally result from such a huge injection of money? Has the Fed said anything about what it intends to do with the interest payments it receives?

5) Any resources related to Federal Reserve accounting or explanations of how its balance sheet works would be greatly appreciated.

I'm looking for accurate financial answers here, not lunacy or chatfilter. Thanks in advance for your help.

posted by Pastabagel to law & government (16 comments total)

Why isn't this inflationary?

Well, it might be:

[T]here were... clear indications that the Fed was taking risks that could dilute the value of the dollar and set the stage for future inflation. Gold prices rose $26.60 an ounce, hitting $942, a sign of declining confidence in the dollar. The dollar, which had been losing value in recent weeks to the euro and the yen, dropped sharply again on Wednesday.

posted by grouse at 7:49 AM on March 19

Some very rough answers:

1) The Fed is buying debt, hoping to pull down interest rates. If they can get interest rates down, that should encourage more lending and thus more economic activity. Inflation and increased real activity often do go together. It may be under the current conditions, there are many productive lending possibilities that aren't being taken, just because of fear. If the Fed can encourage productive lending then they may get increased activity without inflation.

2,3) The Fed creates money by buying debt, and destroys it by selling that debt. I believe the interest payments just go on the Fed's balance sheet. If the Fed decided to buy more debt with the interest money, then that would count as additional money creation.
posted by thrako at 8:07 AM on March 19

Essentially the Fed reverses its position by selling back the debt it is buying now as part of the quantitative easing and burning the money it receives. See these two posts (QE Day / Printing Money) from the BBC's economics editor for more info.
posted by patricio at 8:15 AM on March 19

I liked Merrill economist David Rosenberg's commentary from his memo this morning:

What many pundits seem to be missing is that Fed policy does not operate in a vacuum. The Fed is responding to what we can only refer to as severe trauma on the US household balance sheet. The aggregate loss in household wealth is an eye-popping $12.9tn (and now roughly up to $20 trillion in 1Q): This constitutes a 20% decline in household wealth since the peak was put in back in mid-2007. Wealth destruction of this magnitude is unprecedented since the Great Depression. At the rate it is going, the personal savings rate could be north of 10% within a year – that is a hugely deflationary event unless personal incomes are somehow shored up at the same time (though this is much more effectively addressed via fiscal policy). Yes, indeed, the Fed’s balance sheet and the balance sheet of the federal government are both expanding at record rates. That is what makes the headlines and that is what analysts, strategists and economists will be consumed with today – the latest operation technique by the surgeons. But the reality is that patient is still in sickbay.

These massive reflationary efforts should be seen, in our view, as a partial antidote, not a panacea, to the deflationary effects brought on from the unprecedented contraction in the largest balance sheet on the planet: The $55 trillion US household balance sheet. Based on what house prices and equity valuation have been doing this quarter, we are likely in for a total loss of household net worth approximating $7 trillion this quarter alone, which would bring the cumulate decline in consumer wealth to $20 trillion. This wealth loss exceeds the combined expansion of the Fed’s and government balance sheet by a factor of more than five, which should put the reflation-deflation debate into perspective.

posted by mullacc at 8:59 AM on March 19 [2 favorites has favorites]

These massive reflationary efforts should be seen, in our view, as a partial antidote, not a panacea, to the deflationary effects brought on from the unprecedented contraction in the largest balance sheet on the planet: The $55 trillion US household balance sheet.

But if the dollar has been deflated by the $20 trillion loss of wealth (or 36% of $55 trillion), shouldn't the price of gold have reflected that and gone down?
posted by goethean at 9:30 AM on March 19

Gold isn't the standard, it's just another commodity.

To try to make some of the above more clear: the way the Fed pumps money into the economy is to purchase securities using money that it creates out of thin air. Historically it was T-bills, but it can be anything.

If the Fed wants to drain money out of the economy, they would sell some of the securities they currently own, and turn the money they received back into thin air.
posted by Chocolate Pickle at 9:36 AM on March 19

gothean, Chocolate Pickle is correct: gold is a fine and useful metal, but you have to buy it, you don't buy things with it. The value of the dollar and the value of gold are not related in any significant way.

In general, cash that the Fed receives, just like dollars they have yet to issue, do not count as part of the money supply. When the Mint prints a dollar bill, it goes to the Fed, and it is not until the Fed enters that bill into circulation that the money supply goes up. The Feds non-cash assets don't count as part of the money supply either, but that's just because non-cash assets aren't part of the money supply anyways. So when the Fed buys things, be regardless of what it is, the money supply goes up, but when they sell them, the money supply goes down.
posted by valkyryn at 10:34 AM on March 19

Worth noting: inflation wouldn't be so bad right now, because many economists are concerned about deflation, which would be very, very bad.
posted by awesomebrad at 11:58 AM on March 19 [1 favorite has favorites]

Why isn't this inflationary? To the contrary it is inflationary and that is exactly the effect the Fed is trying to achieve. Right now we have a very dangerous deflationary economy. To counteract that the Fed is intentionally trying to create inflation, but only up to a safer level. 2% to 3% inflation is the level that the Fed tries to achieve long term for stability. Zero inflation is actually unstable. The economy needs a little bit of inflation to unlock sticky prices for efficient markets. A little inflation also provides a safe buffer against much more dangerous deflation.

The Fed buys up treasury bills or bonds that institutional investors have. This has the effect of increasing the prices of the bonds. Like anything else, higher demand for something increases its price. A higher price means lower yield or interest rate. In other words, the more demand there is for bonds, the lower the yield or interest rate. The Fed pays for the bonds it buys by simply creating a deposit in the seller's account at the bank. It creates this deposit out of thin air -- it is just an electronic entry. The bank now has more money on deposit and supposedly is more willing to lend it out, which is the ultimate goal of this process.

If inflation starts to heat up too much, the Fed simply reverses the process. It sells back to investors all of those bonds it bought before. Selling lots of bonds reduces their price, just like flooding the market with any product. If the price of a bond goes down, the yield or interest rate goes up. Higher interest rates slow the economy. The Fed deducts the price of the bond from the bank account of the buyer, thus removing money on deposit at the bank. It destroys the money it previous created out of thin air. The bank has less money to lend out, thereby slowing the economy.
posted by JackFlash at 1:21 PM on March 19

Echoing what people have said above, basically we're in danger of deflation right now, which is much worse than a low rate of inflation. It's more complicated than this, but think of how things are going on sale now- cars, clothes, etc. If no one has any money to spend, prices will adjust downward. The higher savings rate has the same effect. The government is pumping money into the economy to try to spur growth and keep deflation from happening. See this for more details than you probably want.
posted by MadamM at 2:59 PM on March 19

Jack Flash has it exactly right.

It helps to look at the definitions of inflation and deflation. In this context, we are talking about the inflation (increase) and deflation (decrease) in the money supply. This has the effect of rising and lowering prices, but AFAIK, prices are reflections of inflation, not causes of it. Consider this- suppose we still used gold for money. And suppose the worldwide gold supply was 100 million tons. The "economy" is just all of us competing to get our share of that gold so we can buy the stuff we want and need. Now suppose I start digging in my back yard and discover 50 million tons of gold. I, as you would expect, start spending it. This would be inflationary, because I didn't compete in the economy for that gold, I found it. Every ounce of gold I spend devalues the gold the rest of you have. There is the same amount of stuff out there, but more gold. So it takes more gold to buy the same stuff. Inflation.

The Federal Reserve bank is, in essence, a money sink. Or a pressure regulator. A water tower of money. They look at all the indicators of economic activity and figure out what's going on, and adjust the money supply accordingly. They try to counteract the unintended consequences of the mass of economic activity out there, with an eye toward maintaining low inflation and full employment. Too much money out there, they vacuum up dollars. Too little, they pump more out.

(The actions of central banks is so "macro" it's hard to understand. Especially when you get into the various types of money out there, and the weird ways money is created and destroyed. Not only through the open market operations, but also by regulating the reserve requirements of all the other "normal" banks out there. All banks have to keep a "reserve" account with the Fed. Every night, the bank has to tally up their books and make sure a certain percentage of their assets are on account at the Fed. If they don't haven enough, they have to borrow it. The Fed regulates both the amount they must maintain, and the rate at which they borrow it. They adjust these amounts according to their goals- if economic activity is heating up, they can raise the reserve requirement and increase the price for the loans, giving banks incentive to not loan out money, or at least to make it more expensive.)
posted by gjc at 5:30 PM on March 19

The short answer to your original question "How can the Fed Destroy Money It Created?." It destroys money the same way it created it. When the Fed buys a bond from an investor it creates a credit in the seller's bank account thereby creating new money. When the Fed sells a bond to an investor it debits the buyer's bank account, thereby destroying money. In both cases the Fed creates and destroys money out of thin air. When the Fed buys more bonds it tends to increase inflation. When the Fed sells more bonds it tends to decrease inflation.
posted by JackFlash at 6:55 PM on March 19

WRT to comments that the Fed will "simply" destroy money at the right time to get 2-3% inflation, the real risk is they will overshoot, pushing inflation higher than this. In reality, they almost certainly *must* overshoot, as the financial reporting they base their decisions on is historical.
The questions, I feel, are around how the world reacts (especially the Chinese who hold so much US government debt) and how this impacts the fed's ability to act in a timely fashion.
A hypothetical:
- in a year the US$ is falling because of low rates and a reluctance by off-shore investors to buy T-bills. The fed wants to raise rates/destroy money to prop up the dollar, but the economy is still soft and unemployment is high so they can't. Inflation creeps up a bit more, pushed by higher oil prices and other imports and further reluctance of off-shore investors to buy bonds (they were just proven right!). What can the Fed do? Raise rates and kill off an already sluggish economy, or let inflation ride a bit higher and hope increased economic activity will provide some growth to off-set it? Political realities make it hard to see support for a position that will increase unemployment, and inflation helps all those with too much debt, so it creeps a bit higher.
This is alarming to people offshore who can repatriate US assets, so they do, adding to the vicious cycle.
At this point, you can have a Paul Volcker 1980s style period of painful interest rate rises, except even worse with the higher leverage almost everyone has these days, or you can cross your fingers and wait, like the Zimbabweans did.
The US won't have Zim style hyper inflation as its debt is currently denominated in dollars, but what about future borrowings if the lenders will only lend in Euro, when the US is embarking on its greatest period of borrowing ever?
Bernanke is treading an exceptionally skinny tightrope that relies on global sentiment for its integrity - hence China's latest warning about the US acting responsibly to its investors. They will not be looking at the Fed printing money with any fondness (they would rather a Volcker style intervention).
posted by bystander at 6:08 AM on March 20

Creating and destroying money isn't as clear-cut as it seems, as Paul Krugman explains in his blog:

here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent, where it was before the crisis. Then the price of those bonds will have dropped significantly.

And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created. So the Fed will have to sell additional assets; if the rise in interest rates is at all significant, it will have to get those assets from the Treasury. So the Fed is, implicitly, engaged in a deficit spending policy right now.

My back of the envelope calculation looks like this: if the Fed buys $1 trillion of 10-year bonds at 2.5%, and has to sell those bonds in an environment where the market demands a yield to maturity of more than 5%, it will take around a $200 billion loss.

posted by up in the old hotel at 7:59 AM on March 20

The Fed doesn't care if it takes a $200 billion loss. Normal rules don't apply to the Fed, because money doesn't mean the same thing to the Fed that it does to everyone else.
posted by Chocolate Pickle at 5:05 PM on March 21

Thank you for all the great answers and insight. I still curious as to what deflationary effects we have yet to experience, compared to the deflation we have already experienced in 2008. What is left to cause contraction that hasn't already caused contraction? Second order effects of the recently unemployed defaulting on mortgages, etc?
posted by Pastabagel at 8:30 PM on March 21