After two rounds of QE, banks’ balance sheets are awash in excess reserves:
Many commentators find this to be a frightening prospect—the Fed more than doubled the monetary base in just a couple years! Maybe banks are sitting on the money now, but at some point it’ll “get out into the economy” and cause rapid inflation, right?
Not really. Though excess reserves complicate implementation of the Fed’s policy, it has more or less the same options that it always does.
Excess reserves of this magnitude have one important implication: since they have zero value at the margin for making transactions or meeting reserve requirements, banks won’t be willing to hold them if they pay less than federal funds rate. In equilibrium, this means that as long as the excess reserves are on the Fed’s balance sheet, the fed funds rate will be the same as the interest rate paid on reserves.
The Fed still has the ability to set the federal funds rate and conduct monetary policy in exactly the way it normally does. The only difference is that now, rather than using open market operations to hit the target rate, it needs to change the rate it pays on reserves. Since it’s financing long-term asset purchases with short-term reserve deposits, raising interest rates is costly for the Fed. (This is one way that QE might be a useful commitment device for the Fed, as anticipated by Clouse et al. a decade ago.) But there is no question that it has the capacity to do whatever it wants, just as before—and relative to the government’s overall budget, the potential losses from any increase are very small.
Is there any other effect? Not really. Think about it this way: in addition to conducting its normal monetary operations, the Fed also has a traditional banking business on the side, where it accepts a few trillion in deposits at the prevailing interest rate and invests them in long-term assets. Unless the Fed’s solvency is in question (which it isn’t), there’s no reason why this should be inflationary, or tie the Fed’s hands in any way.