There is No Free Lunch in Central Banking

Many observers, including myself, have questioned whether the Fed has the will to reverse the expansion of its balance sheet--the projected $2 trillion plus increase in the monetary base--once the economy starts recovering. While this monetary expansion is necessary now, a failure to reverse it in the future could lead to 1970s-type inflationary pressures. To do so, though, requires a large contraction of the monetary base--whose expansion has largely taken the form of a buildup in banks' excess reserves--which could knock the economic recovery down just as it is getting started. John Taylor, among others, is not convinced the Fed will be able to make such a politically unpopular move.

Via Mark Thoma, we now learn that Susan Woodward and Bob Hall believe this concern is misplaced. They argue in an almost upbeat manner that there is a "simple and effective answer" to this dilemma:

The Fed should raise the rate its pays on reserves as needed to control economic activity and inflation. It is unnecessary for the Fed to cut its reserves to low levels once the economy approaches normal conditions. Rather, it only needs to raise the reserve interest rate to a point sufficiently close to market rates to make banks willing to hold excess reserves.

While this approach may be simple, I am not so sure that it is effective since it implies a potentially large fiscal cost. As the economy recovers, market interest rates will go up and necessitate that the rate the Fed pays on excess reserves also goes up. Given the large stock of excess reserves, the interest payment could turn large. How would the Fed pay for it? The Fed could keep more of its seigniorage, but that would mean less revenue for the federal government. This would be, then, another implicit fiscal cost where banks would be funded by taxpayers.

Once the economy begins to recover I see four potential paths the Fed could take with regards to the large buildup of excess reserves:

1. The Fed could do nothing and allow the inflationary pressures to emerge.
2. The Fed could reverse the buildup of excess reserves and in the process stall the economic recovery.
3. The Fed could pay even higher rates on the excess reserves and potentially incur large fiscal costs.
4. The Fed could pray for super-robust economic growth that would allow the economy to quickly grow (i.e. increase real money demand) into the money supply. This would be the cure all solution--no need to reign in the buildup of excess reserves and no need to worry about inflation.
   

Number (4) is pipe dream. I suspect some combination of numbers (1) and (2) will be the likely outcome. Note that if the Fed pulls a Paul Volker and focuses solely on number (2) it would not only stall the economic recovery but may also incur some fiscal costs. This is because the Fed could have a negative equity position on its balance sheet by that time--interest rates will eventually go up and, in turn, push down the prices on securities currently held by the Fed--that would require it to either borrow securities from the Treasury or issue its own debt in order to reign in the expanded monetary base. The bottom line is there are no easy options ahead for the Fed once the recovery begins.

Update: Michael S. Derby also considers these issues.

Update II: Scott Sumner addresses some of the concerns in this post.