Monetary Cycle Versus Fiscal Cycle: What is the Difference?

Chief Economist Eugenio J. Alemán discusses current economic conditions.

The Federal Reserve (Fed) conducts monetary policy through its main instrument, the federal funds rate, which is the rate banks charge each other in the overnight market. Quantitative easing/tightening, e.g., the buying/selling of Treasurys as well as mortgage-backed securities from the markets, has also become important for Fed monetary policy, but the instrument that guides market interest rates is still the federal funds rate.

In a nutshell, the process works like this: if the Fed wants to decrease the federal funds rate, it buys U.S. Treasurys from the market, injecting liquidity into the market and lowers the federal funds rate. The opposite, which is selling U.S. Treasurys into the market, removes liquidity and increases the federal funds rate.

The federal funds rate is the only interest rate determined by the Fed. The rest of the market rates of interest respond to this federal funds rate.

When the federal funds rate goes down, it injects liquidity into the financial sector and the sector creates money through what is called the ‘money multiplier.’ Thus, money supply increases when the Fed lowers the federal funds rate while money supply declines when the Fed increases the federal funds rate.

Eugenio J. Alemán, PhD,
Click here to enlarge

But the more important question is, was the COVID-19 pandemic a truly monetary cycle? The answer is no. It was not a monetary cycle; it was a fiscal cycle. That is, the increase in money supply depicted in the graph above wasn’t that the financial system went crazy and started lending money like there was no tomorrow and now, because interest rates are going up, it has to call back all the loans in order to dry the market of excess liquidity, as is the case in a monetary tightening cycle. What happened during the COVID-19 pandemic was a fiscal cycle. That is, the government transferred trillions of dollars to individuals and businesses through different programs, from direct payments ($1,200, $600, $1,400 checks) to unemployment insurance payments that included $600 extra per week for individuals who lost their jobs during the pandemic, plus PPP loans that ended up being direct payments because the majority of businesses did not have to pay the money back to the government. This is the reason why money supply skyrocketed during the pandemic, not because banks were lending money.