Inflation, that is. Mankiw says that it’s possible, but that the Fed has all the means to prevent it, if they want to.
“But the Fed has the tools it needs to prevent that outcome. For one, it can sell the large portfolio of mortgage-backed securities and other assets it has accumulated over the last couple of years. When the private purchasers of those assets paid up, they would drain reserves from the banking system.”
(my emphasis added)
Guess what those mortgage-backed securities are. Yes, they are the ones that caused trouble to the banks before they could sell them at overvalued prices to the Fed. Can the Fed really sell this “toxic debt”, as it was once called?
Now, a second argument he brings forth is about the reserves that banks hold at the Fed. Mankiw says:
“And as a result of legislative changes in October 2008, the Fed has a new tool: it can pay interest on reserves. With short-term interest rates currently near zero, this tool has been largely irrelevant. But as the economy recovers and interest rates rise, the Fed can increase the interest rate it pays banks to hold reserves as well. Higher interest on reserves would discourage bank lending and prevent the huge expansion in the monetary base from becoming inflationary.”
(my emphasis added)
As I write this, it’s late and I’m a little bit sleepy already, so please correct me, if I make a major mistake in my argument. I’m just guessing, but how much interest do you have to pay to prevent banks from investing their money into stocks or other securities that return 5-15% p.a.? Does the Fed have the money to pay such interest rates? See, before the crisis the Fed always had a small balance sheet. That was because it’s main purpose was to influence the interest rate that is paid when banks charge each other short-term loans. This doesn’t produce constantly large cash-outflows without inflows, because they do it with so called Repos, which are paid back within a couple of days. They are practically just turning money over and over.
But having to pay interest rates on large amounts of reserves seems to be a totally different animal to me. That would mean constantly large outflow of cash without getting anything in exchange for it. Can they really do it?