In 2020, The Federal Reserve System reduced the bank reserves requirement to zero. Those who should know and care about that change don’t seem to care. Those who might not know should both know and care.

“Monetary policy” has affected the lives of people since the founding of The Federal Reserve in 1913, and usually in a negative way. It has caused the price inflation about which everyone talks, and it has been the primary cause of the business cycles that affect some people more than others.

Fractional Reserve Banking

Fractional reserve banking has been with us for a long time. (See footnotes.) Fractional reserves became legalized and institutionalized with The Federal Reserve Act of 1913.

Fractional reserves set a limit on the quantity of money-dollars that individual banks could create. Depending on the reserve ratio, the amount by which a bank’s actual reserve balance exceeded the required reserve balance (known as “excess reserves”) determined how many additional money-dollars the bank could create. Because the amount of excess reserve remained low for many years, it gave The Fed a great deal of influence over the money-dollar creation of banks. The relatively high degree of influence The Fed had over bank money-dollar creation, and the fact that reserves were also denominated in “dollars” gave people the false impression that The Fed actually “controlled” the money-dollar supply.

Useless Reserve Banking

In 2008, with “Quantitative Easing,” The Fed, under the chairmanship of Ben Bernanke, increased the quantity of reserve-dollars in the banking system to the point at which excess reserves no longer acted as a limiting factor for banks’ ability to create money-dollars.

When the quantity of money (M2) did not expand at a rate comparable to the increase in reserves, many commentators wondered why. They did not realize that Bernanke’s Fed had exposed the truth that The Fed had never created “money.” (See definition.)

Forgive me for coining the term “Useless Reserve Banking,” but the high level of bank reserves made the concept of bank reserves as a policy tool useless.

No Reserve Banking

In 2020, some clever person recognized the uselessness of the reserve requirement and The Fed reduced that requirement to zero. This move eliminated the last vestiges of The Fed’s direct influence over banks’ money-making.

Make no mistake, The Fed still plays a role in the creation and destruction of money-dollars because it is still the largest player in the open market. But, two significant factors have changed:

First, the purchase or sale of securities from/to banks has no leverage on banks’ capacity to create money dollars. The zero requirement leaves the creation of money-dollars up to the discretion of the banks.

Second, the purchase or sale of securities from/to non-banks only causes banks to create money-dollars on a one-for-one basis. If The Fed buys securities from a non-bank entity, that entity’s bank will increase its account balance by the amount of the purchase. Conversely, if The Fed sells securities to a non-bank entity, that entity’s bank will reduce its account balance by the amount of the sale.

Although these transactions will change the reserve balances of the banks involved, because of the zero reserve requirement, it will not affect the banks’ inclination to create money-dollars.

Conclusion

The concept of monetary policy has almost lost its meaning. The Fed influences bank money creation only because it is still the largest player in the open market.

The main influence of the Federal Reserve comes from investors talking about it. Remember the subjective nature of value. If people think the Fed still influences money creation, market actors will adjust their preferences and make this a self-fulfilling prophecy.

Since The Fed has reduced its objective influence over bank dollar creation, could they make the mistake of trying too hard? Since selling securities to non-bank dealers now has only a one-to-one effect on the money-dollar supply, could they, in their attempt to affect interest rates, actually suck too much money from the market. Recent declines in the reported money supply (M2) could indicate trying too hard.

Finally, believe nothing you hear about The Fed and “monetary policy” until you have checked the facts and applied sound reasoning.

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Footnotes:

I have coined the terms “reserve-dollars” and “money-dollars” to designated the distinction between dollars held at The Fed as reserves and dollars held in banks used as money—based on the following definition.

Money Defined:
“Money” consists of any economic good, or any claim on such a good, that serves as a general medium of indirect exchange and that acts as a final means of payment.