I’ve mentioned how the Federal Reserve has bought over $2 trillion of government securities. It has funded that purchase by tripling the amount of deposits held by banks with the Fed — what are called bank reserves.
……. Banks have few good lending opportunities, and so they’re not trying to attract deposits. As a result, they are keeping nearly $1.6 trillion of reserves at the Fed in excess of what they need to back their deposits.
…… Some observers are concerned that ……. the banks’ excess reserves will serve as kindling for an inflationary fire. This concern would have been entirely appropriate three years ago. But in October 2008, Congress granted the Federal Reserve the power to pay interest on bank reserves. Right now, that interest rate is 25 basis points, or 0.25%. By raising that rate judiciously, the Fed has the ability to deter banks from using their reserves to create money, and through this mechanism, the Fed can prevent inflation.
via Fed’s Kocherlakota on Why Balance Sheet Expansion Need Not Be Inflationary – Real Time Economics – WSJ.
Monetary expansion through further asset purchases by the Fed (quantitative easing) would be ineffective, simply boosting the level of excess reserves held by banks on deposit at the Fed. Monetary tightening would be more difficult, but could be achieved by raising the interest rate paid on excess reserves in order to discourage banks from using their excess reserves. That would raise the overnight rate (fed funds rate) in the market and restrict banks from expanding their balance sheets.
