Let Me Explain Inflation Part 2: The Fed and the Government's Love-Hate Relationship

It is the dawn of yet another analysis of inflation. The sun slowly rises as the connection between "printing money", banks, interest rates, and inflation becomes apparent to the reader. It is time: for yet another blog post.

To get the cogs turning, let's take a look at the Federal Reserve. Before we continue, I want to make sure that you know something very important: the Federal Reserve is independent of the federal government, and doesn't have to follow its thoughts at all. We learned two posts ago that the federal government can basically conjure up money from a black hole. How does the black hole work? Why does it exist? Let's look at an example situation to find out:

Remember 2020? COVID? Remember when everyone started panicking about people not buying stuff or borrowing money from banks as much anymore? Back in 2020, the Federal Reserve, or the Fed, started seeing a downturn in economic activity. What it did was it basically gave banks money and said "loan this out as much as possible, give money to people, so that they can spend it and shock the economy into working again." How would it do this? Look and see:

1. Someone at the Fed presses a button and magically (with a huge poof and fireworks, obviously) creates new money (contrary to popular belief, most new money created is actually digital and not paper money). Say it creates $1000.

2. The Fed uses the magically created money to buy bonds: these bonds could be from the US Treasury or they could even be from banks. Whoever it is, the Fed gives the newly created money to them and makes them promise to give it back someday (with the interest cherry on top of the cake). Say it buys from the US Treasury.

3. The entity the Fed bought from is required to keep some of that money in its reserves (for economic security). The rest of that money it can loan out to people. The US Treasury keeps, say, 10% in its reserves, and loans the other $900 out.

4. Some American will borrow our $900 and put it in a bank, which keeps 10% in its reserves and loans $810 out.

If the process continues, we can add up the total amount of money injected into the system. First we add $1000 to the banking system, plus $810 + $648 + $583, and so on. Each successive addition of money to the banking system is smaller, though the total sum is obviously much bigger than the initial $1000. In fact, the total sum converges to $1000/(1-0.9) = $10000, for those of you who want to do the geometric sequence math. This type of Fed policy is called open market operations.

Another way the government increases the amount of money in the economy is to lower the reserve requirement. During COVID, the Fed actually made the reserve requirement zero, basically screaming at banks to JUST LOAN OUT THE MONEY.

Whatever way the government increases the amount of money in the banking system and the economy, this situation happens: Too many dollar bills floating around as the actual worth of each one goes down. The more people take out loans to buy the stuff they want to get, the higher demand there is, and because supply actually decreased during COVID, we saw the runaway hyperinflation that we're still dealing with to this day.

So. That's an explanation of what the Fed tried to do during the pandemic. And don't get me wrong: it could've actually brought more good than harm. Let's look at the goals of this process: it's meant to get people to start borrowing money again to buy everyday goods, homes, fund small businesses, and so on. Now, what would be the worst possible thing that could happen here?

It would be if the general public suddenly had competition for these loans. The government started borrowing so much that suddenly, banks had way too many customers and too little money to hand out. While the Fed was trying to put more money into the economy, the government basically took a lot of it out through its borrowing. This made it harder for people to have access to loans, and banks increased credit requirements, which explains why the bank won't just give you that stupid loan so you can move out of your apartment.

The money the government borrowed got used for endless amounts of wasteful spending (I've harped on this in several posts already). This drove up demand even more, and while inflation caused by the Fed's policies would have been moderate, the inflation caused by all the spending added on to that and led to runaway inflation. Spoiler alert: when you're trying to get rid of something, adding more of it is a really stupid idea.

The government basically undermined the Fed while the Fed undermined the government, and, wow, they're actually still doing it.

There's a few ways you might see this play out in news coverage: when news outlets or economists talk about fiscal policy, what they really mean is policy related to government spending. When they talk about monetary policy, they're talking about the Fed. They're talking about banks. What you'll see in the news is articles about either fiscal or monetary policy, but never both. When the government screws over the Fed and the Fed does the same in reverse, that's when you get screwed over. Doubly. You get the worst of both worlds. If the two actually worked together for once, we'd get the best of both (cue Hannah Montana singing "The Best of Both Worlds").

(It's an amazing song. LISTEN TO IT!!!)