Whenever markets experience turbulence, we hear talk of the Federal Reserve "printing money." The phrase conjures images of enormous printing presses churning out banknotes at a relentless pace, almost as if to suggest that central bankers are manipulating the economy with disarming ease. But the reality is considerably more complex, and understanding what's really happening behind the scenes of American monetary policy can make the difference between investing with knowledge and being swept away by current sentiment.

I decided to address this topic after noticing how much confusion still reigns on the subject, even among experienced investors. The 2020 pandemic brought the role of central banks back to the forefront, with the Fed's balance sheet exploding from approximately $4 trillion pre-Covid to nearly $9 trillion in 2022. Today, after a period of quantitative tightening, that balance sheet has shrunk to approximately $6.5 trillion, but the debate over what all this means for markets and inflation remains as heated as ever.

The nature of money in the modern economy

Before delving into the workings of the Fed, it's important to clear up a fundamental misunderstanding: the money we use every day is not created by governments. Sure, the US Treasury physically prints dollars through the Bureau of Engraving and Printing, but physical currency represents only a small fraction of the money supply. In the United Kingdom, for example, cash makes up just 3% of the money in circulation. The remaining 97% exists in the form of electronic bank deposits.

And here we come to the crucial point: the vast majority of money in the economy is created by commercial banks through the provision of loans. This statement may sound provocative, but it's exactly what the Bank of England confirmed in a 2014 paper titled "Money Creation in the Modern Economy," which made history by debunking several myths prevalent even in university textbooks.

When a bank grants a mortgage, it doesn't dig that money out of some vault full of cash or from other customers' deposits. It simply credits the borrower's account, simultaneously creating an asset for itself (the receivable) and a liability (the newly created deposit). Money literally comes out of thin air, with a few keystrokes on a keyboard. For this reason, some economists have ironically called bank deposits "fountain pen money," created with the stroke of a pen upon loan approval.

The money multiplier: a myth to be debunked

Those who have studied economics will likely remember the concept of "fractional reserve banking" and the "money multiplier." The idea, still present in many textbooks, is that banks collect deposits and then lend a portion of them, retaining a fraction as reserves. This process, repeated multiple times throughout the system, would multiply the monetary base in an almost mechanical manner.

Well, this model has been largely abandoned by economists studying the actual functioning of the banking system. For starters, countries like the United States, the United Kingdom, Canada, Australia, and New Zealand no longer impose reserve requirements on banks. The real limitation on credit creation is not the availability of reserves, but the ability of banks to find creditworthy borrowers willing to borrow at profitable rates.

A 2010 Federal Reserve paper by Seth Carpenter and Selva Demiralp empirically examined the issue, concluding that "changes in reserves are unrelated to changes in lending" and that "open market operations do not directly impact lending." The money multiplier, in short, does not exist in the form traditionally described.

Bank reserves: a special currency

At this point, it's necessary to introduce a fundamental concept: bank reserves. These are a special form of money that exists only within the banking system, in the accounts that commercial banks hold with the central bank. Reserves serve banks to regulate net flows between them: if during a day more money goes out than comes in (because customers make payments to other banks), the bank must cover the difference using its own reserves or borrowing them from other banks in the overnight interbank market.

Here's the key point that many misunderstand: bank reserves cannot be lent to bank customers. As the Bank of England clarified, "Reserves are an IOU from the central bank to commercial banks. They can use them to make payments among themselves, but they cannot lend them to consumers in the economy who do not hold reserve accounts." This distinction is crucial to understanding why quantitative easing did not cause the hyperinflation many feared.

Open market operations: fine-tuning interest rates

We finally come to the tools the Federal Reserve uses to influence the economy. Open market operations (OMOs) are the traditional mechanism through which the Fed manages the fed funds rate, the rate at which banks lend each other money overnight.

Within the OMOs we find two main typologies which are essential to distinguish:

Repurchase agreements (or "repos") are temporary transactions in which the Fed buys securities from banks with the commitment to resell them in the short term, typically the following day. These aren't actual purchases, but rather collateralized loans: the Fed provides temporary liquidity to the banking system by receiving securities as collateral. The reverse transaction, a "reverse repo," works in reverse: the Fed temporarily sells securities, absorbing liquidity from the system.

Outright purchases , on the other hand, are transactions in which the Fed permanently purchases securities, with no obligation to resell them. These purchases steadily expand the Fed's balance sheet and increase bank reserves in the system.

Under the current regime, called the "ample reserves framework" and adopted after the 2008 crisis, the Fed no longer seeks to precisely calibrate the amount of reserves in the system. Instead, it maintains an ample level of reserves and controls rates through so-called "administered rates": the rate paid on excess reserves (IORB) and the rate offered on overnight reverse repos (ON RRP). These two rates create a corridor within which the federal funds rate moves.

Quantitative Easing: Much More Than "Printing Money"

Quantitative easing (QE) represents an evolution of open market operations (OMOs), used when short-term interest rates are already close to zero and conventional monetary policy has exhausted its ammunition. The key difference from traditional OMOs lies not only in scale (QE involves purchases worth trillions of dollars), but also in the type of securities purchased and their duration.

While traditional operations focused on short-term Treasuries, QE saw the Fed purchase long-term Treasuries and, for the first time, mortgage-backed securities (MBS). The stated goal was to lower long-term interest rates, which effectively influence households' and businesses' investment decisions.

Here's what happens mechanically during QE: the Fed buys securities from a commercial bank (or another entity with an account at a bank). In exchange, it credits reserves to that bank's account with the Fed. The central bank's balance sheet expands: the purchased securities appear on the assets side, and the newly created reserves appear on the liabilities side. The commercial bank, for its part, has simply exchanged one asset (securities) for another (reserves). Its net worth hasn't changed.

This dynamic is crucial: QE is essentially an asset swap, not a net injection of wealth into the private sector. The Fed changed the composition of assets held by the private sector, not their overall amount. It removed long-term securities from the market (increasing their prices and decreasing their yields) and replaced them with bank reserves, which are effectively a form of very short-term government debt.

The impact on stock markets

As investors, the question that interests us most is: what effect does all this have on the markets? Economic theory suggests two main channels through which QE can support stock prices.

The first is the portfolio rebalancing effect . When the Fed purchases huge amounts of government bonds and mortgage-backed securities (MBS), it pushes their prices up and yields down. Investors who previously held those securities find themselves with less attractive returns and are incentivized to shift capital into riskier assets, including stocks. This mechanism can create a sort of "wealth effect" that stimulates consumption and, in turn, corporate profits.

The second is the signaling effect . The announcement of a QE program communicates to markets that the central bank is determined to support the economy by any means necessary. This reassurance can reduce risk perception and push investors to take more aggressive positions.

There is empirical evidence of these effects. A 2014 study analyzing the impact of unconventional monetary policies estimated that a surprise 25 basis point reduction in the 10-year Treasury yield was associated with a 0.7% increase in stock prices. However, the same researchers noted that the effectiveness of these tools tends to decline when short-term rates are already close to zero.

And what about inflation? The great fear has been debunked (at least in part).

In 2010, when the Fed launched its second round of QE, a group of economists, professors, and fund managers wrote an open letter to then-Chairman Ben Bernanke expressing grave concerns about the risk of inflation. Their argument was simple: creating all that money would inevitably cause prices to soar.

For nearly a decade, those fears proved unfounded. Inflation remained stubbornly low, so much so that the Fed struggled to bring it back to its 2% target. Japan, which conducted the longest QE experiment in history, struggled for years with deflation, not inflation.

The explanation lies precisely in what we've discussed: QE creates bank reserves, not money that can be spent in the real economy. Reserves remain in the interbank circuit and aren't automatically transformed into loans to households and businesses. To generate inflation, consumers are needed who are willing to spend and banks who are willing to lend to creditworthy borrowers. In a depressed economy, both conditions can fail.

Then came 2021-2022. Inflation exploded, reaching levels not seen since the 1980s. But attributing this phenomenon solely to QE would be an oversimplification. Multiple factors were at play: the massive fiscal stimulus that put money directly into citizens' pockets (very different from QE that affects bank balance sheets), bottlenecks in global supply chains, the energy shock, and the post-lockdown recovery in demand. QE may have contributed by creating more accommodative financial conditions, but it wasn't the only culprit.

The current situation: quantitative tightening and its limits

Since June 2022, the Fed has undertaken the opposite course, known as quantitative tightening (QT). Instead of purchasing securities, it has allowed maturing ones not to be rolled over, allowing its balance sheet to gradually shrink. By December 2025, this process was essentially complete: the balance sheet had shrunk from $8.9 trillion to approximately $6.5 trillion, reversing about half of the pandemic expansion.

At its last meeting in December 2025, the Fed cut rates by 25 basis points to 3.50-3.75%, its third consecutive cut this year. But the decision was not unanimous: three members voted against it, signaling internal divisions over the future direction of monetary policy. Chairman Powell indicated that the Fed is now "in a good position to monitor how the economy evolves," suggesting a pause in the cuts.

An interesting aspect of the latest statement is the announcement that the Fed will resume purchasing short-term Treasuries to maintain an "ample" level of reserves. This isn't a new QE (aimed at lowering long-term rates), but rather Reserve Management Purchases, aimed at providing liquidity to the banking system without impacting long-term financing conditions.

What does all this mean for investors?

After this long excursus into the mechanisms of monetary policy, what are the practical conclusions for an investor?

The first is to avoid monetary determinism. The idea that "when the Fed prints money, markets rise; when it stops, markets fall" is a dangerous simplification. Stock markets reflect a multitude of factors, and monetary policy is just one of them. Anyone who sold their stocks in 2022 at the start of QT, fearing an unstoppable collapse, would have missed out on the subsequent robust gains.

The second is understanding the transmission channels. QE doesn't put money into consumers' pockets; it changes financial conditions by making long-term loans more attractive. If the economy is weak and credit demand is sluggish, this transmission may be ineffective. In contrast, direct fiscal stimulus (family allowances, bonuses, etc.) has a much more immediate impact on aggregate demand.

The third is to monitor expectations, not just actions. Often, the greatest impact of monetary policy materializes at the time of the announcement, before the measures are even implemented. Markets are forward-looking and quickly price in information. When Powell suggests a pause in cuts, the market reacts immediately, without waiting for the formal decision.

The fourth is to maintain a long-term perspective. In the short term, markets can be influenced by expectations about the Fed and monetary policy surprises. But in the long term, what matters are the fundamentals of the companies we invest in: earnings growth, competitive advantages, and management quality. A diversified portfolio built on these criteria shouldn't be upended at every FOMC meeting.

Final considerations

The next time you hear someone say that "the Fed is printing money," you'll be equipped to critically evaluate this claim. The reality is that the Federal Reserve operates through sophisticated mechanisms that alter the composition of assets in the financial system, influence interest rates at various maturities, and provide liquidity to the banking system. These tools can certainly impact markets and the economy, but not in the simplistic way that common parlance suggests.

Money creation in the modern economy occurs primarily through the commercial banking system, when banks extend loans. The Fed can influence this process by adjusting the cost of money and liquidity conditions, but it does not directly control it. Understanding this distinction is crucial to correctly interpreting monetary policy news and making more informed investment decisions.

In an era where the role of central banks is at the center of public debate, with growing political pressures and internal divisions increasingly evident, having a clear understanding of the underlying mechanisms helps us separate the signal from the noise and navigate the markets with greater serenity.