The Fed has been paying interest on excess reserves held by depository institutions since 2009. The Financial Services Regulatory Act of 2006 enabled the Fed to pay interest on excess reserves. The Fed is not the only bank that pursues this policy: the Bank of England has paid interest on reserves since 2009, and the ECB had this facility since 1999. The purpose is twofold: to put a floor on interest rates, and secondly to provide better control of reserves when the Fed exits quantitative easing. However, the dangers of this policy has been emphasized by economists like Eugene Fama, since the payment of interest on reserves uncouples the relation between the monetary base and inflation and the possible advent of inflation, if not hyperinflation when the Fed eventually backtracks and stops paying interest on reserves. The Fed would thereby unleash a genie that it doesn't control anymore precisely because when it did pay interest on reserves, banks thereby accommodated, loosening the link between the monetary base and the inflation rate. Is there any evidence that this might turn out to be the case?
Uncoupling the relation between the monetary base and inflation.
It has already been noted that excess reserves have grown enormously over the past two years, as the following graph shows.
What is also interesting is the relation between bank lending and excess reserves, although the relation between these two variables is not as tight as the relation between currency in circulation and bank lending, since 2011.
Currency in circulation
What about inflationary control?
In recent years, the CPI has grown to be almost completely correlated with currency in circulation and to a much lesser extent to the monetary base.
Consumer price index
Currency in circulation
What about controlling bank lending?
The upshot of the Fed's excess reserve policy has been, furthermore, the uncoupling of the relation between the growth in excess reserves and the growth in bank lending, as banks, satisfied with sitting on their reserves in the Fed hesitate to lend, with a negative correlation of -.04. Again, this negative correlation can have multiple origins, including lack of demand by companies to borrow, poor investment opportunities and recessionary conditions. But at least some of this upside down correlation has to do with the Fed's policies.
Will an eventual taper lead to a greater degree of normalcy?
At this point, it's too early to tell whether an eventual taper will slowly re-establish the relation between the monetary base and inflation. As the Fed slowly releases the mortgage backed securities it holds onto the market, which might eventually absorb them, they might slowly regain control over the inflation rate. Furthermore, slow but sure signs of a recovery would also help, as companies seek to borrow in response to enhanced investment opportunities. But that might take a while.
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