Can the Fed Withdraw Money?

In response to one of my posts last week on Helicopter Ben Bernanke, I received a comment/ question. While it is a fairly easy question to answer, I thought I would expand some thoughts on it and I thought it might be interesting to others.

The comment said, "Just curious.  Can the Fed do negative printing.  By that I mean, can it reduce the money that is out there?  Can it take in dollar bills and burn them if they think inflation is getting out of control?  Or the equivalent in our digital world.  So if the US has $3 trillion in circulation, can they reduce that number to $2.5 trillion somehow?  Not sure why I'm asking, I'm just curious I guess."

The short answer to the question is "yes".  The Federal Reserve can reduce the money supply that is in circulation.  It would not do this by taking in dollar bills and burning them, although technically it probably could do this.  It would do it digitally, doing the reverse of how it created money in the first place.

The Fed creates money out of thin air by buying assets.  Usually these assets consist of government debt.  It does not buy this government debt directly through the government, although there is probably no reason that it couldn't.  It buys it through an intermediary, usually a large bank or financial institution.  It buys the debt and basically does a computer entry onto the bank's books.

If an individual bought a government bond from a bank, then money would transfer from that individual's checking account into the bank's account.  Ownership of the bond would transfer to the individual.  No new money is created in the process.  It is just changing hands.  In the case of the Fed buying a government bond (or lots of them), it is using money created out of thin air to buy.  This is monetary inflation.

If the Fed wants to reduce the supply of money, it can do the reverse and sell the government bonds.  The bank (or whoever is buying the bonds) would transfer money back to the Fed, which would then magically disappear from the system.  It really isn't magic, but it almost seems like it.  This is monetary deflation, as it is reducing the overall money supply, even if just digitally speaking.

The Fed can also reduce the money supply by simply refusing to rollover government debt.  When a bond expires, the Treasury Department would have to pay back the principal amount on the bond.  If the Fed does not buy another bond to replace it, then that money is essentially pulled out of the system, except any money that the Fed uses to pay for its own expenses.

There is a scenario where the Fed may not be able to reduce the money supply to the same extent that it increased the money supply.  If it bought long-term bonds and the rates go up, then the market value of the bonds will go down.  If the Fed sells these bonds in the open market before expiration, it will not be able to sell them for the same price at which they were bought.

The same goes for any other asset.  One area where this subject is particularly glaring right now is mortgage-backed securities.  The Fed started buying these back in late 2008 and paid the full value that the banks had them valued for on their books, even though they were worth far less.  Due to defaulting mortgages, these securities are worth far less than what the Fed paid for them.

Just for example, if the Fed bought $600 billion in mortgage-backed securities and they are now worth only $400 billion, then the Fed would only be able to withdraw $400 billion from the system (from selling these particular assets).  I suppose they could force the banks to buy them back for the full amount, but that would probably bankrupt the banks, which the Fed obviously wouldn't do.  So even if the Fed sold all of the mortgage-backed securities from its portfolio, there would still be a net increase of $200 billion in the money supply from the above example.  This would only be an increase from the last 4 years regarding this particular asset.  Looking at it just from a short time frame of this year, selling these assets now would be monetary deflation.

Of course, the Fed can control price inflation in other ways through manipulation of interest rates, controlling rates paid on excess reserves, and also controlling the required reserves of the banks.  The Fed can also control price inflation simply by telling the marketplace what it plans to do.  If most people believe that the Fed will inflate the money supply significantly in the near future, this in itself can increase velocity and increase price inflation.

There are a lot of variables to consider and that it why it can be quite difficult to predict price inflation, particularly in the short term.  The Fed can certainly sell some assets and reduce the money supply, but I would be surprised if it did this right now, especially since price inflation is relatively low (at least for now) and the economy continues to stagnate.