One of the more common questions I get is about QE and the Fed’s “exit strategy”. Many people seem to think the Fed has to unwind its balance sheet before the Fed can raise rates or tighten policy. So, the concern is that the Fed has a $4.5T balance sheet and when inflation starts to rise they’ll have to hastily unwind the balance sheet which will put pressure on financial markets and the broader economy. But this concern is unfounded. The Fed doesn’t have to unwind the balance sheet to tighten monetary policy.
This was best explained in a 2013 SF Fed piece:
Paying interest on reserves gives policymakers more control over the federal funds rate
The Fed’s new authority gave policymakers another tool to use during the financial crisis. Paying interest on reserves allowed the Fed to increase the level of reserves and still maintain control of the federal funds rate. As the Board’s website states, “Paying interest on excess balances should help to establish a lower bound on the federal funds rate.” The Board’s October 6, 2008, Press Release described the new policy this way:
The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.
This was compelling in the months after September 2008, as the financial crisis deepened, Fed lending from the discount window soared, lending from the newly created liquidity facilities spiked, and excess reserves climbed into the hundreds of billions of dollars range, far exceeding depositories’ required reserves.
In this situation, the Federal Reserve Bank of New York said that the Open Market Desk
…encountered difficulty achieving the operating target for the federal funds rate set by the FOMC, because the expansion of the Federal Reserve’s various liquidity facilities has caused a large increase in excess balances. The expansion of excess reserves in turn has placed extraordinary downward pressure on the overnight federal funds rate. Paying interest on excess reserves will better enable the Desk to achieve the target for the federal funds rate.
Essentially, paying interest on reserves allows the Fed to place a floor on the federal funds rate, since depository institutions have little incentive to lend in the overnight interbank federal funds market at rates below the interest rate on excess reserves. This allows the Desk to keep the federal funds rate closer to the FOMC’s target rate than it would have been able to otherwise.
Interest on Reserves will play an import role in the Fed’s ‘exit strategy’ as well
Finally, the Fed can change the rate for interest on reserves to adjust the incentives for depository institutions to hold reserves to a level that is appropriate for monetary policy. This also provides an important “exit strategy” tool, which will allow the Fed to better control the level of excess reserves when it begins to remove monetary policy stimulus.
Basically, the payment of interest on reserves allows the Fed to maintain control of the Fed Funds Rate even when the balance sheet is expanded. So the Fed can raise interest rates no matter what the size of the balance sheet is because it can simply increase the rate of IOER.
Also, it’s important to note that the Fed likely won’t unwind its balance sheet over time. My guess is that the Fed will simply let the securities on its balance sheet mature which will reduce the balance sheet naturally over the course of time. So the Fed can stop QE at any time and raise interest rates which will tighten monetary policy. And if it really wanted to tighten policy it could kick QE in reverse and raise interest rates. But it doesn’t have to do that to tighten policy. Raising interest on reserves will tighten policy sufficiently when the time comes. And it will do so simply by raising the rate paid on reserves.