At one time the Bank of England and the Federal Reserve decided to embark on ”quantitative easing”, namely the purchase of public bonds in order to supply as much liquidity as possible to the market. What we are doing at present is totally different. We will withdraw all the additional liquidity that we supply.

Deposit institutions are holding over a trillion dollars in excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling.

Why might households expect an increase in inflation? The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve’s debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

My focus is building confidence that real growth is underway and sustainable. Because when that happens, when real growth picks up, if we don’t change policy in the face of that, then we are actually loosening policy. Because as real growth rates pick up, demand for loans is going to pick up, banks are going start converting their excess reserves into lending–which is not necessarily a bad thing, but they could do that very quickly and then all that liquidity starts flowing into the economy. That is the fuel for inflation.

In our explanations of our actions, we have concentrated, as I have just done, on the effects on the prices of the assets we have been purchasing and the spillover to the prices of related assets. The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. Other central banks and some of my colleagues on the Federal Open Market Committee (FOMC) have emphasized this channel in their discussions of the effect of policy at the zero lower bound. According to these types of theories, extra reserves should induce banks to diversify into additional lending and purchases of securities, reducing the cost of borrowing for households and businesses, and so should spark an increase in the money supply and spending. To date, that channel does not seem to have been effective; interest rates on bank loans relative to the usual benchmarks have continued to rise, the quantity of bank loans is still falling rapidly, and money supply growth has been subdued.

 The market’s focus on interest rates is disappointing, given quantitative easing.  Markets are still thinking of monetary policy strictly as changes in interest rates—even though the Fed has been conducting successful policy this past year through quantitative easing. Markets should be focusing on quantitative monetary policy rather than interest rate policy.

Let me be clear for everyone that there is a big distinction between quantitative easing and the -- and the fiscal debt, the government debt. We engaged in quantitative easing, or if you like -- or I've called it credit easing, because it's been focused at trying to get key credit markets functioning again.

We did that for two reasons: first, because we hit the zero bound and therefore normal interest-rate cuts couldn't achieve the goal anymore, and secondly because, in this extraordinary environment, many markets were not functioning properly and we thought we found ways to help those markets work better. And I think we've had some success in doing that.

Now, we have already begun a process of phasing out or reducing many of these extraordinary actions. For example, if you look at the portion of our balance sheet related to short-term lending to financial institutions, to commercial paper markets and to other kinds of international swaps with foreign central banks and other kinds of short-term lending, that amount has dropped from about $1.5 trillion at the beginning of the year to about roughly a fifth of that or less today. And we have announced the closing of certain facilities and planned closings going forward.

So we have already taken some very substantial steps towards moving towards a more normal type of monetary policy. And as long as the economy proceeds along the path that we think it will, we want to continue to move back to more normal monetary policy functioning. We will move to normal monetary policy as called for by the state of the economy, independent of the fiscal situation. We are not involved in that; we are involved in looking at the economy and trying to stabilize the economy.

With respect to fiscal policy, I think everybody knows, including the Treasury, the administration and the Congress, that the kinds of deficits we've seen this year and next year, about 10 percent of GDP, are not sustainable, that we have to find a(n) exit strategy for fiscal policy that will bring deficits down to a level of a few percentage points of GDP, which will result in a sustainable situation where debt, relative to the gross national product, gross domestic product, doesn't grow indefinitely.

From the audience Q&A

Plosser, who is seen as one of the most "hawkish" Fed officials on inflation, reiterated he was "not worried about inflation in the near-term; my worries about inflation are in the intermediate to long-term."

Plosser told Market News the timing and pace of eventual policy tightening will depend on the economy.  "It's contingent on the path of the economy and of inflation ... It's hard to predict now what that may look like," he said.

"All the excess reserves in the banking system that are sitting there right now are not inflationary, but they could become inflationary if we're not careful," he said.

Uncertainty over the outlook for inflation “is as high as it has ever been since 1980”, James Bullard, the president of the Federal Reserve Bank of St Louis, has told the Financial Times.

...

The St Louis Fed president said he would not favour tightening policy before recovery was well-established. “You are going to need to have jobs growth and you are going to need to have unemployment declining.”

But once the recovery looked solid and there were consistent good monthly job gains, the Fed could “remove some of the accommodation”.

Mr Bullard said tightening “does not have to involve as its first step moving the federal funds rate off zero”.

Instead, he favoured at that point selling back assets bought by the Fed in the course of its unconventional easing.

Most Fed officials fear that asset sales would rock the markets and push up long-term interest rates, including mortgage rates. However, Mr Bullard said: “It seems perfectly reasonable to me.” He argued that, with proper planning, asset sales did not need to be disruptive.

Living with a bloated balance sheet for too long would risk fuelling inflation, he warned. “I am concerned that if, over a longer term, you just leave this many reserves in the system, under any ­normal theory . . . that is raw material for the money supply.”

Although the Federal Reserve's approach also entails substantial increases in bank liquidity, it is motivated less by the desire to increase the liabilities of the Federal Reserve than by the need to address dysfunction in specific credit markets through the types of programs I have discussed. For lack of a better term, I have called this approach "credit easing." In a credit-easing regime, policies are tied more closely to the asset side of the balance sheet than the liability side, and the effectiveness of policy support is measured by indicators of market functioning, such as interest rate spreads, volatility, and market liquidity. In particular, the Federal Reserve has not attempted to achieve a smooth growth path for the size of its balance sheet, a common feature of the quantitative-easing approach.

[S]ignificant expansion of the central bank’s balance sheet is not likely to be inflationary during a period when financial institutions are capital-constrained and substantial excess capacity exists in the economy.

In my view, if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal--and the economy has returned to self-sustaining trend growth--they will almost certainly have waited too long. A complication is the large volume of banking system reserves created by the nontraditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending. Predicting the conversion of excess reserves into credit is more difficult to judge due to the changes in the credit channel.

“We have spent 20 years refining ideas about interest rate rules and optimal monetary policy,” Bullard said. “We should now consider quantitative rules because we are at the zero bound, and may remain there for some time depending on how the economy performs.”

Bullard noted that while the FOMC had announced its intention to buy up to $1.75 trillion in asset-backed securities by the first quarter of 2010, “there has been little indication of how or whether these amounts might be adjusted given incoming information on economic performance.”

- from FRBSL press release

In terms of imagery, this concern seems compelling—the banks sitting on piles of money that could be used to extend credit on a moment’s notice. However, this reasoning ignores a very important point. Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not.

These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

In gauging the effects of market interventions in the current crisis, one approach is to look to the size of increases in the quantity of reserves and money to judge whether sufficient liquidity is being provided to forestall deflation and support a turnaround in growth--an approach often known as quantitative easing. The linkages between reserves and money and between either reserves or money and nominal spending are highly variable and not especially reliable under normal circumstances. And the relationships among these variables become even more tenuous when so many short-term interest rates are pinned near zero and monetary and some nonmonetary assets are near-perfect substitutes. In our approach to policy, the amount of reserves has been a result of our market interventions rather than a goal in itself. And, depending on the circumstances, declines in reserves may indicate that markets are improving, not that policy is effectively tightening or failing to lean against weaker demand. Still, we on the Federal Open Market Committee (FOMC) recognize that high levels of Federal Reserve assets and resulting reserves are likely to be essential to fostering recovery, and we have discussed whether some explicit objectives for growth in the size of our balance sheet or for the quantity of the monetary base or reserves would provide some assurance that policy is pointed in the right direction.