Fed Policy and Inflation Risk

CAMBRIDGE – During the past four years, the United States Federal Reserve has added enormous liquidity to the US commercial banking system, and thus to the American economy. Many observers worry that this liquidity will lead in the future to a rapid increase in the volume of bank credit, causing a brisk rise in the money supply – and of the subsequent rate of inflation.

That risk is real, but it is not inevitable, because the relationship between the reserves held at the Fed and the subsequent stock of money and credit is no longer what it used to be. The explosion of reserves has not fueled inflation yet, and the large volume of reserves could in principle be reversed later. But reversing that liquidity may be politically difficult, as well as technically challenging.