August 13, 2022

The banking system excess reserves weaken the link between the monetary base and the quantity of money thereby impacting the effectiveness of the balance sheet reduction as an inflation fighting tool. However, this argument does not apply to the tightening or fed rate hikes. The latter result in a reduction of the money multiplier or banking system leverage factor. The multiplier reduction has a direct impact on M2. The implication of our analysis being that as long as the banking system has a large excess reserve, the tightening policy is the more effective inflation fighting tool at the fed disposal. Therefore, it would be a policy mistake for the Fed to abandon its rake hike policy before the inflation rate returns to the 2% target rate and the excess reserves are eliminated. Also , even though a balance sheet reduction financed out of excess reserves has no impact on M2 and or the inflation rate, it does not mean that the Fed should abandon the policy. A balance sheet reduction will eventually eliminate the excess reserves at which point the reduction in the monetary base will impact the quantity of money and thus the inflation rate. At that point, the Fed will be able to return to the policies that made the Volker Fed so successful.

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