Widely read Seeking Alpha contributor, Cullen Roche, believes that excess reserves will not be a problem for the Fed, because the Fed will begin paying interest to banks with excess reserves. This is discussed in his article, "Why The Fed Doesn't Have to 'Unwind' QE".
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.
At first glance, a reader might believe that this policy does no harm to the public. The public puts money in the bank and, in days before the financial crisis, receives interest. So, proponents argue, "Why shouldn't banks holding excess reserves get paid interest too? How would the public be hurt?"
In an-around-about way they would be hurt - that is how. You see, the "residual earnings" of the Fed are "distributed to the U.S. Treasury, after providing for the costs of operations, payment of dividends, and the amount necessary to equate surplus with capital paid-in."
Currently, there is over $2.6 Trillion USD of excess reserves at the Fed.
This means, that if the Fed began paying 1% interest on reserves, when it began to "tighten", then $26 Billion USD ( $2.6 Trillion x 1% = $26 Billion) would be reduced from the amount distributed to the US Treasury.
Since the US Government has constant deficits, this then means another $26 Billion in borrowing. In 2013, the US Government spent $415 Billion on interest expense. The US Federal Debt outstanding also averaged $16.793 Trillion during 2013. This means an approximate 2.48% average rate of interest.
IF the US Government financed the "missing" $26 Billion, at 2.48%, for 10 years then approximately $6.45 Billion more would be spent on interest (this is a "back of the envelope" simple interest calculation).
Some might argue that the Fed will collect more on "new" bonds as it rolls over bonds that come to maturity; however, this line of thought is not as convincing as it first might appear. This is because in the next year less than .09% of the $2.3 Trillion in US Treasury Notes, which the Fed Holds, mature.
One can see in the above table that the Fed now holds no US T-Bills. 56% of the portfolio is in US Treasury Notes and Bonds. The Fed might receive more interest from its MBS, but how will it account for the loss in value of its holdings that remain on its books? Will it use "Held to Maturity" rules? But then what happens if it ever sells a bond out of its portfolio?
The most challenging environment would be an inverted yield curve. Then the interest paid to banks would be higher than both Treasuries and MBS.
At the end of the day, it is again the US taxpayer who gets the short end of the stick with this proposed "pay interest on reserves" policy. Notice the residual earnings paid to the US Treasury are after "payment of dividends" to banks in the Federal Reserve system.
In General. After all necessary expenses of a Federal reserve bank have been paid or provided for, the stockholders of the bank shall be entitled to receive an annual dividend of 6 percent on paid-in capital stock. (Source)
Imagine that; in a world starved for yield, banks are already guaranteed a 6% payment for their paid-in capital, and now they want interest on their reserves too! It's time for policy makers to rethink this approach. If the economy is "heating" up then why would a conventional policy tool of selling assets not work? And why should the US taxpayers have their money absconded from them to the banks?
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