Concerns over the surge in excess reserves in the U.S. banking system and its potential to fire up inflation are largely unwarranted, according to two New York Federal Reserve economists.
The jump in excess reserves, or the amount of funds banks hold beyond what the U.S. central bank requires, is largely the by-product of the unprecedented lending the Fed has conducted to combat the credit crisis and the ensuing recession, Todd Keister and James McAndrews wrote in an article for the New York Fed's December bulletin released on Thursday.
Moreover, burgeoning excess reserves signal little or nothing about the programs' effects on bank lending or on the economy more broadly, they said in the article, entitled: Why Are Banks Holding So Many Excess Reserves.
Some Wall Street economists have cited the estimated $1.1 trillion in excess reserves as a failure of the Fed's monetary measures to stimulate lending. Instead of making loans, banks are sitting on their cash.
Other private economists have warned the Fed needs to act quickly to remove the large quantities of excess reserves once the economic recovery gains traction, or it will risk stoking inflation.
To combat inflation, the Fed has two monetary tools to curb bank lending and overall economic activity, Keister and McAndrews said.
First, the central bank can sell securities -- primarily U.S. Treasuries -- to banks through reverse repurchase agreements. It has begun conducting tests of so-called triparty reverse repos this month.
The scale of reverse repos, however, is limited by the amount of securities the Fed owns.
The other tool is raising the interest rate the Fed pays on reserves. The Fed began paying interest on reserves in October 2008, shortly after the collapse of Lehman Brothers roiled global financial markets.
By increasing the interest it pays on reserves, the Fed can raise short-term market rates and slow bank lending and the economy without changing the quantity of reserves, Keister and McAndrew noted.