While Harris said he expects interest on reserves to be an effective tightening tool, it’s still “unlikely, frankly” the Fed will hold assets to maturity because elevated bank reserves, while not currently inflationary, may cause the economy eventually to overheat.
“If the Fed were to leave reserves in the banking system too long, and there were to be a big surge in spending -- absolutely, we have an inflation problem,” he said.
Not all policy makers are convinced that holding onto the bonds is a viable strategy. Philadelphia Fed President Charles Plosser told reporters after a March 6 speech in Lancaster, Pennsylvania, that it’s too soon to know whether the Fed can withdraw its easing this way.
“I don’t know how we can commit to never selling,” Plosser said. “We don’t know the answer to that, so it’s hard to pre-commit, to say we can’t sell assets even in the face of rising inflation.”
Robert Eisenbeis, a former research director at the Atlanta Fed, also said he doubts the central bank can control inflation just through paying interest on reserves.
“You can’t do it,” said Eisenbeis, who’s now chief monetary economist at Cumberland Advisors in Sarasota, Florida. “They’re naive in that sense. Their models are one thing, but the real world is another.”
Eisenbeis said the Fed doesn’t “know what the elasticity of demand” is for reserves in the banking system and proposed that policy makers raise reserve requirements to a very high level now. Then they could commit to reducing the requirements as the economy expands, regulating the amount of cash banks have to lend out, he said.
Returning the balance sheet to normal would “make the whole exercise of controlling the funds rate a lot cleaner,” said Antulio Bomfim, a senior managing director at Macroeconomic Advisers LLC in Washington and a former Fed economist.
The fed funds effective rate traded at 0.15% on March 8. That’s 0.1 percentage point less than financial institutions earn for parking their cash at the central bank.
“There is always some slippage between the funds rate and the IOER rate,” Bomfim said. “So you might say that’s not a big deal now, but once you start raising rates, you might want the link to be a little bit tighter. One way is to take the reserves out of the system.”
Bomfim forecasts the Fed ultimately will go ahead with sales that “would be gradual and well-communicated in advance.” Given it’s an untested tool, the Fed would “want to tread lightly.”
Bernanke said Feb. 27 that it would “be maybe an extra year” before the central bank’s balance sheet got “back down to a more normal size” if policy makers choose not to sell securities.
“Most on the FOMC and outside the Fed agree it would be best for the balance sheet to get back to normal,” Barclays’ Maki said. “The disagreement comes about how quickly, over what kind of time frame that normalization should occur.”