30 Years of U.S. Money Supply and Interest Rates

Money supply and interest rates are important macroeconomic factors that can change the direction of entire economies.

In the United States, the Federal Reserve, also known as the Fed, uses open market operations to influence these factors and fulfill its “dual mandate” of maximum employment and stable prices.

But how is money supply associated with interest rates?

How Money Supply Affects Interest Rates

Interest rates determine the cost of borrowing money in an economy. The higher the interest rate, the more expensive it is to borrow money, and vice versa.

By the law of supply, when there is less money in the economy, the cost of borrowing money tends to be higher. All else being equal, a decrease in money supply corresponds to higher interest rates, and by contrast, an increase in money supply tends to put downward pressure on interest rates.

Central banks use monetary policy—the macroeconomic policy that manages interest rates and money supply—to improve economic health. However, the nature of the monetary policy differs based on the state of the economy:

• Expansionary Monetary Policy
  Expansionary monetary policies aim to stimulate economic growth by increasing the money supply, lowering interest rates, and increasing demand, spending, and investment in the economy.
• Contractionary Monetary Policy
  Contractionary policies aim to slow down unsustainable economic growth and inflation by decreasing the money supply, increasing interest rates, and reducing spending while facilitating saving.

Today, the U.S. Fed is employing expansionary monetary policy, with near-zero interest rates and some of the fastest growth rates for M3 money supply ever seen.

But how has the Fed’s monetary policy changed over recent decades?

Economic Booms and Busts in the U.S.

Between 1990 and 2020, the U.S. money supply (M3) increased from around $3 trillion to $19 trillion, a rate that far exceeds that of economic growth.

During this time, the U.S. economy went through major shocks that affected its monetary policy.

The 2001 Recession

Internet and tech-based companies came to dominate the U.S. economy by the end of the 1990s.

During the same period, the Fed eased its monetary policy, with the goal of reducing interest rates and increasing liquidity in the economy. Excess money supply also went into the stock market, propelling the NASDAQ index to new highs at the time.

To curtail rising inflationary pressures and an overheating stock market, the Fed raised its Fed funds rate target six times between June 1999 and May 2000, reducing money supply growth. This, in turn, slowed down the flow of capital into the stock market in the lead-up to the dot-com crash and the recession that followed.

The 2008 Financial Crisis

The 2008 recession was the most severe economic downturn in the U.S. since World War II.

In an effort to spur the economy out of recession, the Fed dropped its rate target from 3.5% in January of 2008 to near-zero rates by the end of the year. Additionally, it also started a series of large-scale asset purchase programs (also known as quantitative easing), accelerating money supply in the economy.

From the end of 2008 to 2015, the Federal Open Market Committee (FOMC) established near-zero targets for the Fed funds rate in order to support economic activity and job creation.

The 2020 Recession

The pandemic-induced recession of 2020 called for policymakers and central banks around the world to take action.

In response to the financial turmoil, the FOMC dropped its Fed funds rate target by 1.5 percentage points to a range of 0% to 0.25%. It expects these near-zero interest rates to stay until 2023. Furthermore, at the end of 2020, M3 money supply was up by almost 25% year-over-year, the largest yearly increase since 1961.

The Fed’s response to economic turmoil involves large changes in money supply and the Fed funds rate, which affects not only the short term but also the long-term direction of the economy.

The Future of U.S. Money and Interest Rates

An economy’s money supply has a strong association with the currency’s purchasing power and inflation, although there are other factors at play. As the number of dollars in the economy increases, the amount of goods and services that can be bought with one dollar falls as price levels rise.

Due to the policy response during the pandemic, inflation has become a growing concern for investors and consumers alike. With money supply at unprecedented highs and interest rates near all-time lows, it’ll be interesting to see how long it takes for the U.S. economy to recover and rates to rise again.