Will Banks' Excess Reserves Fuel Future Inflation?

by: Mark J. Perry

The chart below (click to enlarge) shows how the monetary expansions knows as QE1 and QE2 have expanded the monetary base (blue line) in about the same proportion as the increase in the excess reserves that banks are holding (red line, data here).

Why are banks holding so many excess reserves, and will those reserves eventually translate into higher inflation?

Here's one explanation from the conclusion of a NY Fed research paper titled "Why Are Banks Holding So Many Excess Reserves?":

We also discussed the importance of paying interest on reserves when the level of excess reserves is unusually high, as the Federal Reserve began to do in October 2008. Paying interest on reserves allows a central bank to maintain its influence over market interest rates independent of the quantity of reserves created by its liquidity facilities. The central bank can then let the size of these facilities be determined by conditions in the financial sector, while setting its target for the short-term interest rate based on macroeconomic conditions. This ability to separate monetary policy from the quantity of bank reserves is particularly important during the recovery from a financial crisis. If inflationary pressures begin to appear while the liquidity facilities are still in use, the central bank can use its interest-on-reserves policy to raise interest rates without necessarily removing all of the reserves created by the facilities.

In a blog post, Donald Maron summarizes the paper this way:

Some have expressed concern that the excess reserves are fuel for future inflation. The authors argue, quite rightly in my view, that this concern is also misplaced. The key reason is that the Federal Reserve gained a new power in 2008 — the ability to pay interest on reserves. That ability breaks the traditional link (in U.S. monetary policy) between reserves, bank lending, and inflationary pressures.