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.

As best we can tell, so far the {GSE and Treasury securities purchase} programs are having the intended effect. For example, 30-year fixed mortgage rates, which responded very little to our cuts in the target for the federal funds rate, have declined 1 percentage point to 1-1/2 percentage points since our first MBS purchase program was announced in November. Over time, lower mortgage rates should help to improve conditions in the housing market, whose persistent weakness has had a major impact on economic and financial conditions more broadly, and will improve the financial condition of some households by facilitating refinancing. In addition, open-market purchases should benefit credit markets by adding liquidity and balance sheet capacity to the system.

Even though the conventional measure of the stance of monetary policy is the central bank’s interest rate target, monetary policy fundamentally is always about the amount of monetary liabilities issued by the central bank – also known as the “monetary base.” After all, hitting an interest rate target requires varying the quantity of central bank money, reducing the supply to raise rates and increasing the supply to reduce rates. Even when the policy rate has been driven down to zero, central banks can still dictate the supply of central bank money. And changes in the monetary base can still provide economic stimulus. Even if the funds rate does not change in response to an increase in the monetary base, some other rates of return must change to induce banks to voluntarily hold the additional supply of bank reserves.

Eventually economic conditions will improve, demand for excess reserves will fall, and in order to maintain price stability, the Fed will have to begin withdrawing the extraordinarily large supply of liquidity with which it has flooded the market. Under normal operating procedures, this isn't a problem, as the Fed holdings are mainly short-term Treasuries, which can be liquidated to reduce reserves and increase interest rates.