Randy Wray says:
The Federal Reserve on Monday proposed allowing banks to park their reserves at the central bank, a move aimed at weaning the economy off extraordinary infusions of cash and curbing inflation. The Fed would create the equivalent of a certificate of deposit that pays interest to banks for keeping some of their reserves — which are currently estimated at more than $1 trillion — for up to one year. That would help offset some of the $2.2 trillion the central bank has fanned out into the economy during the financial crisis. It also would allow the Fed to quickly entice banks to take more money out of circulation in case inflation emerged as a serious threat in the near future. The proposal was the latest sign the Fed is intensifying its efforts to scale back the vast amounts of money it pumped into the economy at the height of the crisis.
This blog has published a number of pieces explaining why there is no need to worry about the trillions of dollars of reserves and cash created by the Fed to deal with the run to liquidity set-off by this crisis (see here and here). As and when banks decide they do not want to hold reserves, they will retire their loans at the discount window and will begin to purchase higher-earning assets. As this pushes up asset prices (reducing interest rates), the Fed will begin to unwind its balance sheet—selling the assets it purchased during the crisis. Retiring discount window loans plus purchases of assets from the Fed will eliminate undesired reserve holdings. It is all automatic and nothing to worry about or to plan for. And it will not set off a round of inflation. The old "money multiplier" view according to which excess reserves cause banks to lend, which induces spending, which causes inflation, was abandoned by all serious monetary theorists long ago. Chairman Bernanke ought to abandon it, too.
This is a good article despite the calls for more fiscal stimulus – a position I am moving away from because of the likelihood of malinvestment. I have to admit to falling prey to the money multiplier fallacy mentioned here. It is maddeningly easy to do. I too have written about inflation worries regarding the Fed’s exit strategy. These worries were unconsciously based on the discredited reserves-lead-to-credit view of fiat money which Bernanke seems to follow.
In reality, only the demand for credit can increase inflation, not the amount of reserves in the system. With a huge amount of excess capacity and structurally high unemployment, I suspect the only things which will inflate any time soon are asset prices. And the only way this will lead to consumer price inflation is through commodity prices, as oil is trading for almost $80 despite 2009 U.S. oil consumption demand being at its weakest in over a decade. Gold is not the only commodity acting like money.
Fed Offers New CD; Chairman Bernanke is still confused – L. Randall Wray