Federal Reserve chairman Bernanke testified last Tuesday (July 21) that there is no inflation danger even though the Fed is keeping short-term interest rates very low and the banks are awash with excess reserves (lendable cash), to the tune of some $800 billion, which if used for loans rather than left sitting in the banks' accounts in federal reserve banks would increase the amount of money in circulation by a considerable amount. Bernanke explained that if signs that unwanted inflation is looming appear, the Fed can head off the inflation in a variety of ways. One way, he emphasized, would be by paying interest on reserves at a rate that would increase the interest rates that banks would charge for loans and by doing so reduce the amount of money in circulation. Suppose the Fed paid 3 percent interest (at present it is paying .25 percent) on reserves; then a bank would have no incentive to lend at any lower rate. Indeed, it would insist on a significantly higher rate, since lending to the Fed (the banks' excess reserves are held in federal reserve banks, and so in effect are loans to the Fed, on which the Fed pays interest) is riskless. Another way to stop inflation would be for the Fed to sell securities to the banks (or to others) and retire the cash it received, thus reducing the amount of money in circulation. It could do other things as well.
But there are two clouds in this otherwise sunny scene. The first is that the device for reducing the amount of money in circulation with which Bernanke led in his testimony--paying interest on bank reserves on order to increase interest rates--has not been tried before by the Fed. It sounds as if it would work, but until it is true, no one can know.