Background - Inflation in the Future
Through quantitative easing and other expansionary monetary policies, the Federal Reserve had dramatically expanded the monetary base of the US economy.
From September 2008 to June 2014, the monetary base has gone up from $870 billion to $4 trillion. Essentially, the Fed has more than quadrupled the amount of money in the banking system. At present, inflation is not a major problem because most of this high power money is being held by banks as excessive reserves.
As of June 2014, around $2.6 trillion was held as excessive reserves by US depository institutions. And since banks were unwilling to lend out their excessive reserves, money creation has not happened to a great extent and there was limited growth in the money supply.
However, if the economy continued to recover, banks would gradually lend out more and more of their excessive reserves, due to:
i. An increase in the demand for loans by corporations and consumers.
ii. Lower risk and uncertainty should promote lending on the supply side.
And when this happens, money supply would expand dramatically as a result of money creation. If left unchecked, this expansion of the money supply could lead to serious inflation problems in the future.
The Fed's Biggest Hurdle in Dealing with this Inflation
Now, at first glance, the worry that economists have about the upcoming inflation seems to be unfounded. After all, even if this "lending-out" of the excessive reserve would cause inflation problems in the future, the Federal Reserve could simply reduce the amount of bank reserves and prevent money creation from happening. But remember, currently there are around $2.6 trillion worth of excessive reserves outstanding. To sufficiently reduce inflation in the future, the Federal Reserve might have to reduce the monetary base by a number close to this amount.
Now, what options would the Federal Reserve have? It could cut back on its special lending programs and normalize the discount window. But these actions would only reduce a relatively small amount of the monetary base compared to the amount of excessive reserves. To sufficiently reduce its balance sheet, the Fed must significantly reduce its holdings of mortgage-backed/long-term securities that it had purchased through QE. And while it could certainly do that, by dumping trillion dollars' worth of assets back to the market, the Federal Reserve would wreak havoc in the markets for these securities.
It appears as though the central bank would be trapped between a rock and a hard place. Using only the conventional approach of security sales to fight inflation, the Federal Reserve must inevitably cause disruption in the securities market. Could there be another way out?
The Deposit Rate Strategy - Suppressing Inflation without Security Sales
Of course, the central bankers did not proceed onto quantitative easing without considering the possible consequences of their actions. Prior to QE, the Federal Reserve had planned out an exit strategy to deal with the possibility of runaway inflation (a very good article detailing the Fed's exit strategy could be found here). And in this strategy, a key instrument to curb inflation is the deposit rate, or interest on reserves.
To be more specific, the Federal Reserve plans to increase the deposit rate to suppress inflation. In order to understand how this works, note that when the central bank increases the deposit rate, they will reduce the opportunity cost for banks to hold on to excessive reserves. Normally, when the economy is booming, the banks hold on to very little excessive reserves because the opportunity cost of holding on to excessive reserves is very high. But if the Fed raises the yield on the deposit rate to a level high enough, it can eliminate this opportunity cost. At that point, excessive reserves will become substitutes to very safe short term securities such as T-bills in the banks' portfolio.
Thus, even if the economy fully recovers, the Fed can "persuade" the banks to hold on to some of their excessive reserves through a generous yield on their reserves. And this is precisely what the central bank will do to prevent inflation. If the economy continues to recover, the big worry is that banks would cause runaway inflation by lending out their excessive reserves (thus dramatically increase the money supply). But if the Federal Reserve can use the deposit rate to prevent the excessive reserve from leaving the banking system, it could solve the inflation problem without having to sell any of its securities.
Another Unconventional Tool of the Fed : Reverse Repo
Other than raising the deposit rate, the Fed is also planning to use reverse repos to control the money supply. The underlining concept between reverse repos and paying an interest on reserves is similar. The Fed will pay a "premium" to fix the money supply. In a reverse repo, the Fed temporarily reduces the monetary base by selling securities to banks, which the Fed will then repurchase at a higher price (hence the premium) later on. To reduce the monetary base for an extended period of time, the Fed must continuously renew their reverse repo contracts, and thus, they will also need to pay out a constant stream of premiums. In effect, this is not much different than using the deposit rate to keep the money supply fixed; as in both cases, the Fed is more or less paying the banks (through an interest rate on reserves vs. a premium on the reverse repo) to keep their funds from leaking out the loanable market and cause inflation.
Closing Remarks: Good Strategies in Theory, but Many Things Could go Wrong in Practice
Now, it would almost appear as though the Federal Reserve has created for itself a few magic bullets to control inflation. At first glance, these strategies will provide the Fed with alternative means to curb inflation without resorting to a massive-scale security sale. But do take note that these new strategies are untested and that they can potentially cause many problems when put into practice.
In a later article, I plan to write an analysis of the biggest problems with the Fed's exit strategy and a discussion of what profit opportunities these new strategies could present.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.