Potential Inflationary Effects of Excess Reserve Balances
For the better part of 2009, throughout the great expansion in excess reserves, the potential inflationary effects have been amply debated. It is conceivable that since the Fed now pays interest on the excess reserves, that the excess reserves themselves place an effective cap on the Fed Funds before the Fed begins to lose money on interest payment mismatches between its liabilities and assets. This could curtail the Fed's ability to maintain inflation expectations well-anchored.
Although research by the Fed found that it is interest paid on reserves that helps to guard against inflationary pressures. Under a traditional operating framework, in which central bank controls interest rates by changing the level of reserves and pays no interest on excess reserves, it would need to remove almost all of these excess reverves to raise market interest rates. Now when central bank pays interest on excess reserves the link between the level of reserves and willingness of commercial banks to lend is broken. It allows central bank to raise market interest rates simply by raising interest rate it pays on reserves without changing the quantity of reserves thus reducing lending growth and curbing economic activity.
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