What is the end game for American monetary policy?

The economic recovery will soon enter its sixth year. Experts now predict that economic growth will pick up speed this year and next. The Federal Reserve, which deserves much credit for preventing the financial crisis and Great Recession from turning into a depression, now faces the critical task of ending its lengthy program of quantitative easing without triggering a new recession or igniting a spike in inflation.

During the various quantitative easing programs, the Fed grew its balance sheet from about $1 trillion in assets in August 2008 to more than $4.3 trillion today. At the same time, bank reserves exploded from $45 billion to $2.7 trillion and and excess reserves skyrocketed from $2 billion to $2.6 trillion. Currently, the banking system holds $1.72 in reserves against every dollar in transactions (checking) accounts. These are unprecedented numbers.

A significant share of the run-up in reserves came from the Fed’s decision to begin paying interest on bank reserves in October 2008. The 0.25 percent (25 basis points) interest rate — it exceeded the rate on Federal funds, which fell to nearly zero — provides little incentive for banks to loan overnight funds to other banks.

Some analysts see the huge overhang in excess reserves as the fuel that could ignite destructive inflation. That is, a more normal situation in credit markets will allow banks to use the excess reserves to dramatically increase credit (new loans) and money (checking accounts), leading to significant inflation.

Until recently, analysts wondered how the Fed would unwind its balance sheet and absorb the overhang of excess reserves. Traditionally, the Fed sells government securities in the open market. Such action withdraws liquidity, reduces asset prices and drives up interest rates. But withdrawing liquidity too quickly can drive up interest rates too fast, stalling recovery. Withdrawing the liquidity too slowly can leave interest rates too low, overheating the economy and igniting inflation.

Rather than withdraw this excess liquidity, however, the Fed now plans to keep the size of its current balance sheet and lock up excess reserves so they cannot finance excessive growth of money and credit and, thus, overheat the economy. How does the Fed do this? It increases the interest rate paid on bank reserves.

Although this strategy apparently differs from the traditional approach, the same dangers exist. First, if the Fed raises the interest rate on reserves too little, then more reserves will finance money and credit creation than desired, overheating the economy and sparking inflation. If the Fed raises this interest rate too much, then more reserves will remain in the Fed and the economic recovery will slump back into recession. These two approaches do differ in one aspect: whether the existing excess liquidity remains in the system.

An additional danger exists with this new strategy. When the private sector demands more credit for spending, the reserves to finance this desire already reside on bank balance sheets. Thus, credit expansion occurs without explicit Fed action. The Fed, in this case, must react to, rather than lead, events.

A third strategy combines the first two. The Fed can adjust the interest rate on reserves in the short run to lock up excess reserves. Then, it can withdraw the liquidity from the system in a more measured and less frenetic pace than may be required if the Fed implements the traditional approach.

No matter what the Fed does, it faces the risks outlined in the first paragraph. The Fed needs a Goldilocks outcome — neither too little nor too much credit creation, but just the right amount. The Fed currently operates in uncharted waters, and the possibility of navigational error is high. The third strategy of using the interest rate on reserves to lock up excess reserves in the short run and withdrawing the excess liquidity from the system in a sustained and systematic manner provides the best policy choice. This choice also gives the Fed more control over the economy. That is, this strategy eliminates the ability of banks to supply increased demands for credit without explicit Fed action, which inherently exists when excess liquidity remains in the system.

Stephen M. Miller is a professor of economics in the Lee Business School at the University of Nevada, Las Vegas and Chairman of the Board of Directors of The Economic Club of Las Vegas.