He waived aside concerns that the massive increase in excess reserves--bank reserves deposited with the Fed in excess of the required amount--will rush into inflation. Despite a prediction that Fed assets will rise to $2.5 trillion, Dudley maintained that the ability to pay interest on excess reserves acts as a spigot on bank lending.
"If banks are earning no interest on their excess reserve holdings, they will be willing to lend those reserves out to any creditworthy borrowers as long as the interest rate is positive after adjusting for risk. The borrowers would then spend these monies, thereby boosting economic activity. The funds would not disappear, but instead would flow back into the banking system as they were deposited by those who had received the income generated by the increase in spending, thus replenishing the reserves that had been lent out in the first round of lending. This would result in a new stock of excess reserves that would then lead to a second round of credit creation and a further increase in economic activity. This cycling of excess reserves into credit creation, and the corresponding increase in economic activity, would continue until the excess reserves were fully absorbed by an increase in currency outstanding and/or an increase in required reserves associated with the rise in the amount of banking deposits. Inflation would rise as the excessive credit creation generated by the excess reserves led to an overheated economy and a rise in inflation expectations.But that is not the world in which we now live. Because the Federal Reserve now has the ability to pay interest on excess reserves (IOER), it also now has the ability to prevent excess reserves from leading to excessive credit creation. Because the Federal Reserve is the safest of counterparties, the IOER rate effectively becomes the risk-free rate.3 By raising that rate, the Federal Reserve raises the cost of credit more generally because banks will not lend at rates below the IOER rate when they can instead hold their excess reserves on deposit with the Fed. Because banks no longer seek to lend out their excess reserves, there is no increase in the amount of credit outstanding, no redeposit of the excess reserves, no increase in economic activity and no risk that excessive credit creation will fuel an inflationary spiral.
For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply and credit outstanding consistent with its dual mandate of full employment and price stability."
It's not immediately obvious to me how the IOER plan differs from open market operations by the FOMC. The last paragraph of the passage quoted above provides a sobering reminder that the Fed plays a political role, full employment, as well as a monetary role in price stability. In an inflationary recovery scenario, the Fed must compete with the capital markets for funds, but it must also control the drainage so as to avoid impairing the recovery. Compared to open market operations, the IOER does not appear to offer a major advantage in dealing with the dual mandate.
