In effect, paying interest on reserves gives the Fed a more nuanced approach to shrinking the mountain of excess reserves, but it does not eliminate the problem of the potential inflationary impulse unless the Fed is willing to leave the mountain alone for a long time. That seems unlikely.

That, at least, is how it appears at the moment.

Unfortunately, this report ignores the effect of the interest being paid to banks for their reserves. That money will enter the system and, in all likelyhood, be held by banks as excess reserves. While the Fed may have the ability to prevent those excess reserves from being paid out in the form of new loans, the Fed currently doesn’t have the ability to prevent those profits from being paid out to bank shareholders as dividends. As that money enters the system there could be a boom of private lending that would enjoy a competitive advantage over banks with arbitrarily high interest rates. Inflation would likely follow as reserves bleed into M1. There’s no such thing as a free lunch.

In the new system, the Fed could do the same open-market operation, but the money wouldn’t necessarily get lent by the banks. If the Fed offered a high enough interest rate on reserves, the banks would just turn around and park the money there.

In the old system, high reserves would thus signal money that the banks wanted to lend, but hadn’t injected into the economy yet. Under the new system, high reserves might just mean that the Fed is paying a high-enough interest rate .