The Fed will have no problem handling inflation, according to New York Federal Reserve Chief William Dudley.
Some believe the Fed’s expanded balance sheet, enlarged by its lending facilities and purchase programs, will eventually cause inflation.
That would be the case in the past, but the Fed can now pay banks interest on excess reserves (IOER), which will stop those reserves from creating inflation, Dudley said in a speech in New York.
By raising that IOER rate, the Fed can raise the cost of lending and control excess inflationary credit. Banks won’t lend at rates below the IOER rate because they can hold excess reserves on deposit with the Fed, Dudley explained.
“It is important that this critical issue be well understood,” Dudley said.
If people believe the Fed cannot easily move to an inflation-fighting, tight-monetary stance, the belief alone will promote inflation by increasing long-dated bonds, he said.
The Fed, taking a belt-and-suspenders approach, also has tools to drain excess reserves from the banking system.
San Francisco Fed President Janet Yellen, talking to bankers in Idaho, agreed that the Fed can act fast to control inflation. High inflation in the 1970s, she said, was partly because of policy mistakes that the Fed will not repeat.
Yet, she said, increasing rates any time soon would be premature.
“We have got to be ahead of the curve,” she said, but added, “This is not the time.”
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