The Federal Reserve: Back to the Past

Abstract

The Federal Reserve's payment of interest on bank reserves balances has transformed the balances to investments rather than just insurance against a run on the banking system. The paying of interest on reserves allowed the Federal Reserve to engage in an unprecedented increase in its assets without incurring significant inflation in the economy. The Federal Reserve recently announced that it will begin a gradual reduction in its asset portfolio. This reversal of the almost decade long increase in Federal Reserve assets will require a slow, but careful process. This process must account for the effect of the policy on the Federal Reserve's annual inflation target. In this study, the scale of the asset reduction required to return the Federal Reserve's assets to GDP ratio back to its pre-Great Recession level is measured. Using simple analysis, the magnitude of the problem and the factors that make the transition possible are estimated. This analysis demonstrates the wisdom of the slow approach envisioned by the Federal Reserve Board. Going forward, uncertainty about the future path of market interest rates is particularly important.