Did the Fed's 0% reserve rule cause inflation?

The popular theory: 0% reserves

Why and how did prices jump so fast after 2020? There's a popular theory. In March 2020, the Fed cut banks' reserve requirement to zero. No more holding back up to ten percent of checking deposits. So banks went wild, money poured out, and prices exploded. It's a tidy story. It's also mostly wrong, and the real answer is more interesting.

Why the reserve rule had stopped mattering

Remember from our last video: banks create new money when they lend. In theory, the reserve requirement capped that. In practice, it had stopped mattering more than a decade earlier. After the 2008 crisis, the Fed flooded banks with reserves and started paying interest on them. By 2020, banks were holding about one and a half trillion dollars more in reserves than any rule required. So cutting the requirement to zero changed almost nothing about how much they could lend.

M2: the money supply explosion

But the money supply really did explode. The broad measure called M2 grew about forty percent in two years, from roughly fifteen trillion dollars in early 2020 to more than twenty one trillion. That was the fastest growth in generations. So where did all that money come from?

Source 1: ~$5 trillion in pandemic relief

Mostly from Washington. Across 2020 and 2021, under both administrations, Congress passed about five trillion dollars in pandemic relief: stimulus checks, expanded unemployment benefits and business loans. The government borrowed to pay for it, and the money landed straight in people's bank accounts as brand new deposits.

Source 2: Fed bond buying and near-zero rates

At the same time, the Fed bought trillions of dollars of government and mortgage bonds, roughly doubling its balance sheet to about nine trillion dollars. And it held interest rates near zero for two years. Cheap money, plus a flood of new deposits, pumped up demand.

Source 3: supply shocks and energy

Then supply broke. Factories shut down, shipping jammed, chips ran short, and many workers stayed home. In 2022, Russia invaded Ukraine and energy prices soared. Too much money was chasing too few goods. Inflation hit nine point one percent in June 2022, the highest in about forty years.

The Fed slams the brakes

So the Fed slammed the brakes. Starting in March 2022, it raised rates at the fastest pace since the early 1980s. Borrowing got expensive, lending slowed, and the money supply actually shrank, something that hadn't happened in more than sixty years. Inflation cooled. But prices didn't go back down. They just stopped rising as fast.

Recap

So the zero reserve rule wasn't the culprit. Huge government spending, a Fed that kept money cheap, and broken supply chains were. ThatsWhyHow.