The Federal Reserve is America's central bank. Its job is to manage the U.S. money supply, and for this reason, many people say the Fed "prints money." But the Fed doesn't have a printing press that cranks out dollars. Only the U.S. Department of Treasury can do that. The Fed has a good many other monetary powers, however.
- People say the Fed is "printing money" because it adds credit to accounts of federal member banks or lowers the federal funds rate.
- The Fed takes both of these actions to increase the money supply.
- The Bureau of Engraving and Printing, under the U.S. Department of Treasury, does the actual printing of cash for circulation.
How the Fed "Prints" Money
Most of the money in use is not cash. It's credit that's added to banks' deposits. It’s similar to the kind of credit you receive when your employer deposits your paycheck directly into your bank account.
When people say the Federal Reserve "prints money," they mean it's adding credit to its member banks' deposits.
The Federal Open Market Committee (FOMC) is the Fed’s operational arm, guiding monetary policy. It engages in expansive monetary policy when the Fed expands credit. It increases the money supply available to borrow, spend, or invest. Expanding credit helps to end recessions.
The Fed mainly uses two of its many tools to implement monetary policy.
The Federal Funds Rate
The Fed lowers the target for the federal funds rate when it wants to "print money." Fed funds are what banks are required to hold in reserve each night. A bank will borrow fed funds from another bank to meet the requirement if necessary. The interest rate it pays is referred to as the "fed funds rate."
The FOMC allows banks to pay less for borrowed fed funds when it lowers the target for the fed funds rate. Banks have more money to lend because they're paying less in interest.
The Fed typically requires that banks hold 10% of their deposits in reserve. This reserve requirement was lowered to zero in March 2020 to fight the recession caused by the COVID-19 pandemic.
Banks would like to lend every dollar they don't have to hold in reserve, so they comply as soon as the FOMC lowers the fed funds rate target. They then reduce all other interest rates.
That makes capital more affordable, so businesses and investors are more likely to borrow. An investment will look like a good idea if its return is expected to be higher than the interest rate. High liquidity spurs economic growth in this way. That’s just like adding money to the money supply.
Open Market Operations
The Fed’s other tool is open market operations. The Fed buys U.S. Treasuries and other securities from its member banks and replaces them with credit. All central banks have this unique ability to create credit out of thin air. That’s just like printing money.
Quantitative easing (QE) is a massive expansion of open market operations. The Fed used QE in response to the COVID-19 pandemic in 2020.
The Federal Reserve announced on March 15, 2020, that it would purchase $500 billion in U.S. Treasuries and $200 billion in mortgage-backed securities over the next several months. The FOMC expanded QE purchases to an unlimited amount on March 23. Its balance sheet grew to $7 trillion by May 18.
The Fed initially launched QE between December 2008 and October 2014 in response to the 2008 financial crisis. It added $4 trillion to the money supply by January 2014. This had the same impact on the economy as printing 40 billion $100 bills and mailing them to banks to lend.
The Fed Can "Unprint" Money, Too
Expansive monetary policy can create inflation when it's overdone. The prices of assets increase as cheap capital chases fewer and fewer solid ventures. That's true whether the investments are in real estate, gold, oil, or stocks of high-tech companies.
The most commonly used measure of inflation, the Consumer Price Index, doesn't record all these price increases. It captures oil prices but not gold or stock prices. It measures housing, but it uses a statistic that measures rental rates, not houses for sale. That's why the Fed's actions can easily create asset bubbles as well as inflation.
People worry about the Fed printing money because they don't understand that the Fed can "unprint" it just as quickly.
The Fed uses contractionary monetary policy to dry up liquidity. This has the same effect as taking money out of circulation.
The Fed raises the fed funds rate to reduce the amount of capital in the money supply. Banks have less money to lend when this happens. They have to pay each other more to keep fed funds in the overnight account in order to fulfill the Fed's reserve requirement.
Raising the fed funds rate causes all interest rates to increase.
This practice makes it more expensive to borrow for business expansion, automobiles, and homes. It slows economic growth, drying up the demand that drives inflation.
The Fed can also reverse the effects of quantitative easing (QE). It does this by selling Treasuries and mortgage-backed securities to its banks. The Fed removes dollars from the banks' balance sheets and replaces them with these securities.
What happens to the dollars? They vanish. In other words, they go back into thin air, where the Fed got them in the first place.
How the Treasury Prints Money
The Bureau of Engraving and Printing (BEP) designs and manufactures U.S. currency and securities. One of its major goals is to prevent counterfeiting. The currency's design also conveys dignity, the power of the U.S. economy, and familiar markings that distinguish it as American. The BEP uses distinct designs, paper, and ink. It added subtle background colors to improve security in 2003.
U.S. currencies are made of 75% cotton and 25% linen.
Security threads and watermarks are woven into the paper for $5 notes and higher. The front of the bill uses a color-shifting ink, and the $100 bill has a 3D security ribbon.
After a final inspection, the BEP sends completed currency to the nation's central bank, the Federal Reserve.
The Fed Decides How Much Money Is Created
The Fed decides how much money gets made. That's true for both credit and paper currency. Paper currency is officially called Federal Reserve notes. There was $2.05 trillion worth of these notes in circulation as of February 2021. The Fed spent $751 million to manage the currency in 2020. It pays for printing, transportation, and destruction of the mutilated currency.
The Federal Reserve Board estimates how much demand there is for paper currency. Most of it goes to replace mutilated or outdated bills.
Another Way the Fed Creates Money
The Fed's ability to create and destroy money gives it another power: It's able to monetize the U.S. debt. When the U.S. government auctions Treasuries, it's selling U.S. debt to Treasury buyers. The Fed is one of these buyers. It keeps the Treasuries on its balance sheet. Technically, the Treasury must pay the Fed back one day, but the Fed has given the federal government more money to spend until that happens.
The Fed does this by removing those Treasuries from circulation. Decreasing the supply of Treasuries makes the remaining bonds more valuable. These higher-value Treasuries don't have to pay as much in interest to get buyers. The lower yield drives down interest rates on the U.S. debt. Lower interest rates mean the government doesn't have to spend as much to pay off its loans. That's money it can use for other programs.