Can the Fed Unprint Money?

Ben Bernanke has pumped vast sums into the economy. What happens when he wants to reel it back in?

JPMorgan Chase, the country's biggest bank by assets, reported a record quarterly profit Friday.
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Americans have had four years to wrap their heads around the concept of the Fed "printing" money, which it does via a policy known as quantitative easing. But when the economy is humming again, the Fed will shut down its theoretical printing presses. Then, there will be another brain-buster to think about: Can we unprint all of that money?

Yes, but it can take some mental gymnastics to understand, especially for those of us who aren't central bankers.

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There are a number of ways to "unprint" money. One short answer to how this might happen is that the money will go back into the ether from whence it came.

"Just as they can create money by buying bonds, they can sell bonds and receive cash for those bonds and effectively extinguish that cash," says Guy LeBas, chief fixed income strategist at financial services firm Janney Montgomery Scott.

Understanding how a dollar can be "extinguished" is easier with a recap of how all of that money was printed in the first place. In quantitative easing, the Federal Reserve buys assets—treasury bonds, for example, or bundles of mortgages known as mortgage-backed securities—from banks. The central bank recently announced that it would undertake a third round of easing, widely known as "QE3" for short, which involves buying $40 billion in those mortgage bundles each month.

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The goal is to stimulate the economy—ideally, banks then lend the money from those sales out to people and businesses who want to buy things like houses or equipment, boosting consumption and the economy.

But where did all of that money come from? That's where the strangeness of quantitative easing comes in. The Fed can create money, as policy wonks say, "ex nihilo"—out of nothing. It simply creates new monetary value, then buys bank assets with it. And it's worth noting that it was able to do this well before "quantitative easing" became a hot topic.

It's not exactly "printing money," in other words, but the goal is to increase the money supply. The problem is that the banks aren't yet lending out the money from those large-scale purchases on a large scale.

"[Federal Reserve Chairman] Ben Bernanke did his proverbial helicopter drop, and the problem is the money got stuck in the trees," says Diane Swonk, chief economist at Mesirow Financial. Or, in other words, banks didn't get that money out and moving through the economy.

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Since the start of the crisis, the Fed's balance sheet—its ledger of its assets and liabilities—has grown sharply, from around $900 billion in mid-2008 to $2.8 trillion now.

That problem of those pesky mitigating factors, like risk-averse banks, makes "printing money" an imprecise, even clumsy, economic fix. If too many dollar bills ever do fall out of the branches—that is, if banks start lending again en masse—it could mean inflation, as more money is suddenly loosed on the economy. If that inflation grows too large, that's where unprinting might come in, or as the Federal Reserve might put it, "unwinding" its assets.

One way to reel money in is simply the reverse of the initial "printing" process: selling assets off.

But then what? Where do the proceeds go? Back into nothingness, is the short answer.

One way to think about it is accounting. The Fed is holding all of those assets, and its liabilities are the banks' reserve balances. When the Fed sells off an asset and gets that money back, its assets and liabilities both decrease—a sort of canceling-each-other-out effect, says LeBas.

Of course, the Fed has other ways of getting money out of the system. One of the easiest and fastest ways is by manipulating interest rates to discourage lending, as Bernanke outlined in an October 2009 speech.

"In general, banks will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve," he said.