Is there a way out? Here's one thing that could help. As I have argued for some time, the Fed should reduce the interest rate it pays on the roughly $1.7 trillion of banks' excess reserves. If it did so, banks would keep less cash on deposit at the Fed. The liberated funds would probably flow mainly into the money markets, but some would probably find their way into increased lending—which would give the economy a little boost.This is incorrect. No funds are "liberated" if the Fed reduces the interest rate on reserves. Outside money (currency plus reserves) does not go away unless the Fed actually sells assets. For example, a reduction in the interest rate on reserves from 0.25% to 0% would reduce the willingness of financial institutions to hold reserves, but that can only mean that, ultimately, that currency will increase and reserves will decrease by the same amount, in nominal terms. Prices would have to change as a result. For example, suppose that the demand for currency is fixed in real terms. Then prices have to rise as a result of the reduction in the interest rate on reserves. The balance sheet would be smaller, in real terms. Obviously this is not a "way out," as the key problem has to do with what happens if inflation gets too high and the Fed needs to tighten. See my post on The Balance Sheet and the Fed's Future.
In either case, if banks wanted to hold fewer reserves—a Fed liability—the Fed could, and naturally would, shrink its assets by an equal amount. Balance sheets do, after all, balance. And that would make the eventual exit easier.
Wednesday, March 13, 2013
Alan Blinder Discusses the Fed's Balance Sheet
Alan Blinder has a piece in the Wall Street Journal on the size of the Fed's balance sheet and why it does and does not matter. Mostly this looks fine, but at the end of the article, he discusses a possible exit strategy from some difficult choices for the Fed: