The Fed's fourth tool

President William Dudley of The New York Fed dismissed fears of future inflation due to the massive increase in excess reserves by noting that the Fed had a new monetary tool.

Even aside from this major factor, Dudley argued that the Fed's large and growing balance sheet is nothing that prevents the Fed from controlling inflation once the economy corrects. 'It is not the case that our expanded balance sheet will inevitably prove inflationary,' he said.

Specifically, Dudley said the Fed's new ability to pay interest on excess reserves is a critical tool it uses to keep banks from lending these reserves and thereby creating new credit and boosting inflation. 'Thus, through the IOER rate (interest on excess reserves), the Federal Reserve can effectively retain control of monetary policy,' he said, noting that the Fed can increase the IOER rate if banks begin to find it more profitable to lend these reserves.

He complete speech is here. I need to revise my material on the Fed as the result of what it has done in the last year, and writing that the Fed now has four tools to control monetary policy--open market operations, the discount rate, reserve requirements, and the interest on excess reserves--is a first step. I wonder, though, if this does not make their job harder rather than easier.

Here is more from the Fed on what new Fed powers, found on Donald Marron.