Let Markets Determine the Money Supply

M onetary policy has been described as the art of filling a bathtub to the brim without it overflowing — the tub being the national economy, the water being the amount of money within it. Fill the tub too low, and the economy lacks enough money to match its productive capacity, resulting in needless deflation and contraction. Fill it too high, and the economy suffers from overstimulation and inflation.

The aim of central banks should be to provide exactly as much money as the economy demands. No more, no less. But that’s an impossible challenge when officials must fine-tune the stream of money creation month to month with woefully imperfect information. Markets and the central bank end up locked in a guessing game, each trying to predict the other’s next move. Kevin Warsh, the new chair of the Federal Reserve, has offered less “forward guidance” to break the cycle. Yet investors are still left trading on the data they know the Fed is watching. A solid jobs report sends stocks down, and a bad report sends them up.

The greater problem for most Americans is that the Fed has enormous discretion over the money supply’s growth, which it almost always biases toward inflation. Its stated target is annual inflation of 2 percent, or dollars losing half their value every 35 years. (It has well exceeded this target for the past five years.) Every emergency is met with zero percent interest rates and direct money printing, known as “quantitative easing,” to juice the financial system. Monetary policy has been so loose for so long that most Americans think 5 percent interest rates are abnormally high rather than historically moderate. Yet deflation also poses a grave risk, as America learned during the Great Depression. As the country’s productive capacity grows, so does its demand for money.

Conservatives have long tried to balance these risks with “monetary rules” that would remove most of the Fed’s discretion by keeping the money supply on a steady path. Milton Friedman’s “K-percent rule” would grow it by a fixed percentage every year. John Taylor’s “Taylor rule” would base policy on whether GDP growth exceeded or lagged its estimated potential. More recently, conservatives have turned to a nominal GDP target, calibrating policy so economywide spending grows at a predetermined rate.

All these frameworks are, in different circumstances, both too restrictive and too loose. The K-percent rule would produce inflation or deflation whenever economic growth or the velocity of money (how often it changes hands) departs from the set rate. The Taylor rule depends on an output gap that can never be known, disguising discretion as a formula. A nominal GDP target would force the Fed to constantly play catch-up with old data. And any binding rule could stop the Fed from supplying a sudden influx of reserves when every bank needs one at once, as in 2008, when the central bank was the only entity that could provide it.

The Fed’s proper role, then, is to extend only as large a money supply as the U.S. economy genuinely demands. We’re back to trying to fill the bathtub just so. But what if the fatal assumption of past models is that the water must be managed by an external force? What if market actors within the economy were given complete control over both the faucet and the drain? They could determine the money supply at precisely the level they need in real time. Moreover, this approach would go a long way toward ending both the guessing game between markets and the Fed and the inflationary bias of discretionary policy, while still meeting every genuine demand for liquidity.

Given the existing Federal Reserve system, creating such a new regime would be technically quite simple. The Fed currently uses three main tools to govern monetary policy. First, it puts a ceiling on benchmark market interest rates by freely lending to banks through the “discount window,” so no institution will borrow money at a higher rate. Second, it imposes a floor on interest rates (a fraction of a percentage point lower than the ceiling) by paying banks interest on reserves parked at the Fed, so no institution will lend money at a lower rate. Lastly, it conducts “open market operations” by buying bonds from banks with newly created dollars (and sometimes selling them back), thereby determining the amount of money banks have available to lend out to the broader economy. (The Fed used to have a fourth tool, “reserve requirements,” which required banks to withhold a certain percentage of their reserves, but those requirements were eliminated during Covid.)

In just three steps — each one transforming a different policy tool — the Fed could make monetary policy wholly responsive to market forces:

1. Close the Discount Window: The Fed’s primary mechanism for controlling interest rates can be shut down immediately, freeing rates to rise however high as lenders and borrowers see fit. This private market already meets almost all of banks’ liquidity needs, albeit under a price ceiling, since very little money is lent through the discount window in normal times. Borrowing has only spiked in emergencies — the 2008 financial crisis, the early pandemic, and amid 2023 bank failures — and this crucial function can be fulfilled another way. The Fed could create a new lending facility, open exclusively during severe financial stress, that extends liquidity under the classical conditions set by English writer Walter Bagehot for lenders of last resort: It should lend only to solvent banks, against good collateral, and at above-market interest rates. Benchmark rates would still be determined by market forces.
2. End Interest on Reserves: To fully end the Fed’s control of interest rates, we must eliminate the floor as well as the ceiling. The central bank only began paying interest on bank reserves in 2008, to manage how much of the newly printed reserves got out into the broader economy. (More on this function later.) Today, banks hold just shy of $3 trillion in reserves at the Fed instead of lending that money or buying securities like bonds. Ending interest on those reserves would make every dormant dollar an unprofitable investment, though banks would still require a (far lower) baseline amount of reserves to maintain liquidity and keep transacting with one another.
3. Turn Open Market Operations into a Two-Way Liquidity Valve: This would be the most technically complex reform. When the current Fed wants to inject money into the financial system, it purchases bonds — typically federal Treasuries — from banks at whatever price gets the transaction done, and dollars appear as new reserves. When it wishes to tighten this “base” money supply, it either sells the bonds back to banks or lets them roll off its balance sheet as they mature, extinguishing the money it receives. But what if the Fed stopped initiating bond transactions entirely? Instead, it would turn the machinery of open market operations into a purely responsive liquidity valve. Depository institutions would be free to buy or sell Treasury bonds to the Fed, at preexisting fair market prices determined by the far larger private Treasury market, in exchange for dollar reserves. If a bank demanded more reserves, it would sell bonds to the Fed in whatever quantity it needed. If another bank demanded fewer reserves, it would buy Treasuries from the Fed at the same price. Central bankers’ job would solely be to ensure price discipline on bonds — no discounts or bonuses to banks — and to keep the valve open to all comers.

Under this system, which would retain the same basic monetary infrastructure, the amount of base money held by financial institutions would be chosen by each institution individually. So long as Treasuries are abundant — and there’s no risk of running low anytime soon — banks should be able to meet their exact demand for dollar reserves at fair market prices. The broader money supply — composed mostly of checking accounts, savings accounts, and money market funds — would still flow from the newly uncontrolled credit market, creating bank deposits and using reserves to settle transactions. But loans would be offered at true market interest rates — set by the intersection of America’s supply of real savings and demand for credit — and would only be made if their return exceeds that of the extremely safe bonds that banks could get from the Fed, also set by the market.

The liquidity valve, meanwhile, functions as both the money supply’s spigot and drain simultaneously. When people demand more money, they can get it by selling bonds to financial institutions — serving as effective intermediaries — which can then sell them to the Fed. When people demand less money, they can do the reverse and purchase bonds through the valve. Liquidity needs could always be met, and excess money would no longer be trapped in the economy, circulating and inflating prices. In the long run, market actors will hold only enough money to facilitate needed transactions and savings based on real-world conditions, trading any surplus for interest-bearing bonds. Credit creation can temporarily push the money supply above what people want to hold, but excess dollars would be drained as people repay debt or buy Treasuries, thereby destroying deposits while the valve replenishes banks’ bond holdings.

An open, two-way valve would break the chain between credit volume and broad money supply. If lenders create more deposits than the public wants to hold, it can shed the surplus money by buying bonds from banks. Conversely, if borrowing is too low to meet the public’s demand for money, it can convert any number of Treasuries into dollars. Once the Fed relinquishes control of interest rates, it wouldn’t have to regulate the underlying monetary base to keep rates within a given range. Growth in the broad money supply would equal net credit-created deposits plus the public’s net conversion of bonds into dollars through the banking system.

The components of the reform also fit together for a seamless transition. Once interest on reserves is ended, banks will immediately seek to get rid of the trillions of dollars earning them nothing. Rather than lend them out in an inflationary credit surge, the liquidity valve would allow banks to immediately exchange their pent-up reserves for interest-bearing assets. The Fed has more than enough bonds to cover every dollar of bank reserves. It could take the opportunity to sell its entire $1.9 trillion portfolio of mortgage-backed securities accumulated since the Great Recession back to private institutions, as Kevin Warsh has advocated to end distortions in the housing market, in one go. That would leave the valve to run wholly on the Fed’s enormous Treasury holdings.

Financial emergencies would be met with as much liquidity as solvent banks request via the valve, but not the flood of easy money that distorts markets and inflates new bubbles. (Illiquid banks without sufficient Treasuries could rely on the lender-of-last-resort facility in a crunch.) Markets couldn’t anticipate the Fed’s actions and vice versa, because it would make no affirmative decisions. The Fed would lose its ability to artificially stimulate employment and economic growth, yet the monetary authority was never the proper venue for such objectives. Stripped of discretion, central bankers could no longer initiate cycles of inflation and contraction.

The Federal Reserve’s job is, or ought to be, the provision of only so much currency as the market for money demands. After 113 years of centralized governance and market manipulation, the millions of people who make up the U.S. economy should be free to decide that amount for themselves.