The financial markets shook with fear last month when the minutes of the Federal Reserve’s meeting suggested that the US central bank might reconsider the costs of pumping nearly $1.7tn of excess reserves into the banking system. Of particular concern to members of the Federal Open Market Committee is the inflationary potential of these reserves if the banks turn them into loans and deposits.
Before the financial crisis, banks held few reserves in excess of their requirements. This allowed the Fed to control closely the level of deposits that are extended when banks create loans. But today’s huge supply of excess reserves means financial institutions can create trillions of dollars of loans and deposits, which will be highly inflationary.
To eliminate these excess reserves, the Fed would have to sell more than half its nearly $3tn portfolio of Treasury bonds and mortgage-backed securities. Given that the Fed has indicated that reversing its quantitative easing would be done only in a rapidly improving economic environment – which normally puts pressure on bond prices – further bond sales from the central bank could be destabilising to the financial markets.