Much of the debate surrounding the Federal Reserve's new asset purchase plan considers whether or not it will effectively stimulate the economy. But an equally important question is whether the Fed will manage to avoid high inflation, despite its incredibly large -- and growing -- balance sheet. The Fed swears that its exit strategy will do the trick, but Harvard economist Robert Barro isn't convinced. He doesn't believe that the Fed will be able to both avoid inflation and shrink its balance sheet without harming the economy. In a great analysis of the Fed's program and exit strategy he explains why raising interest rates on reserves isn't likely to work any better than simply selling bonds:

The Fed thinks it can improve on the exit strategy by instead raising the interest rate paid on reserves. For example, if rates on Treasury bills rise to 2%, the Fed could pay around 2% on reserves to induce institutions to maintain the excess reserves of $1 trillion held at the Fed. However, at that point, it would still be true that open-market operations involving reserves and bills would not matter. That is, the Fed's selling off $1 trillion of Treasury bills (if it had that much) in exchange for $1 trillion of reserves would have no effect. This reasoning implies that the exit strategy of raising the interest rate on reserves in tandem with the rise in interest rates on bills is equivalent to the standard contractionary open-market policy. That is, the effects on the real economy are the same.

Read the full story at the Economist.

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