Tag Archives: Ample Reserves

The Case Against Interest On Reserves

05 Monday Jan 2026

Posted by in Interest Rates, Monetary Policy

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This topic flared up in 2025, with legislation proposing to end the Federal Reserve’s payment of interest on bank reserves (IOR). The bills have not yet advanced in Congress, however. As a preliminary on IOR and its broader implications, consider two hypotheticals:

First, imagine banks that take deposits, make loans, and invest in assets like government securities (i.e., Treasury debt). Banks are required to hold some percentage of reserves against their deposits at the central bank (the Fed), but the reserves earn nothing.

Now consider a world in which the Fed pays banks a risk-free interest rate on reserves. Banks will opt to hold plentiful reserves and relatively less in Treasuries. But in this scenario, the Fed itself holds large amounts of Treasuries and other securities, earns interest, and in turn pays interest to banks on their reserves.

The first scenario held sway in the U.S. until 2008, when Congress authorized the Fed to pay IOR. Since that time, we’ve had the second scenario: the IOR monetary order.

Socialized Risk

The central bank can basically print money, so there is no danger that banks won’t be paid IOR, despite some risk inherent in assets held by the Fed in its portfolio. While the rate paid on reserves can change, and banks are paid IOR every 14 days, they do not face the rate risk (and a modicum of default risk) inherent in holding Treasuries and mortgage securities, which have varying maturities. Instead, the Fed and ultimately taxpayers shoulder that risk, despite the Fed’s assurances that any portfolio losses and negative net interest income are economically irrelevant. These risks have been socialized, so we now share them.

This means that an essential function of the banking system, assessing and rationally pricing risks associated with certain assets, has been nationalized. It is a suspension of the market mechanism and an invitation to misallocated capital. Why bother to critically assess the risks inherent in assets if the Fed is happy to take them off your hands, possibly at a small premium, and then pay you a risk-free return on your cash to boot.

Bank Subsidies

IOR is a subsidy to banks. They get a return with zero risk, while taxpayers provide a funding bridge for any losses on the Fed’s holdings of securities on its balance sheet or any shortfall in the Fed’s net interest income. Banks, however, can’t lose money on their ample reserves.

The subsidy may come at a greater cost to some banks than others. This regime has been accompanied by significantly more regulation of bank balance sheets, such as capital and liquidity requirements (Basel III and Dodd-Frank). Not only is IOR a significant step toward nationalizing banks, but the attendant regulatory regime tends to favor large banks.

On the other hand, zero IOR with a positive reserve requirement amounts to a tax on banks, which is ultimately paid by bank customers. Allowing banks to hold zero reserves is out of the question, so we could view the implicit reserve-requirement tax as a cost of achieving some monetary stability and promoting safer depository institutions.

Quantitative Easing

Again, the advent of IOR created an incentive for banks to hold more reserves and relatively less in Treasuries and other assets (even some loans). Rather than “scarce reserves”, banks were encouraged by IOR to hold “ample reserves”. Of course, this is thought to promote stability and a safer banking system, but as Scott Sumner notes, it represents a contractionary policy owing to the increase in the demand for base money (reserves) by banks.

The Fed took up the slack in the debt markets, buying mortgage-backed securities and Treasuries for its own portfolio in large amounts. That kind of expansion in the Fed’s balance sheet is called quantitative easing (QE). which adds to the money supply as the Fed pays for the assets.

QE helped to neutralize the contractionary effect of IOR. And QE itself can be neutralized by other measures, including regulations governing bank capital and liquidity levels.

Fed Balance Sheet Policies

QE can’t go on forever… or can it? Perhaps no more than expanding federal deficits can go on forever! The Fed’s balance sheet topped out in 2022 at about $9 trillion. It stood at just over $6.5 trillion in November 2025.

Quantitative tightening (QT) occurs when the Fed sells assets or allows run-off in its portfolio as securities mature. Nevertheless, the Fed’s mere act of holding large amounts of debt securities (whether accompanied by QE, QT, or stasis) is essentially part of the ample reserves/IOR monetary regime: without it, the demand for debt securities would be undercut (because banks get a sweeter deal from the Fed, and so disintermediation occurs).

In terms of monetary stimulus, QE was more or less offset during the financial crisis leading into the Great Recession via higher demand for bank reserves (IOR) and stricter banking regulation. Higher capital requirements were justified as necessary to stabilize the financial system, but critics like Brian Wesbury stress that the real destabilizing culprit was mark-to-market valuation requirements.

During the Covid pandemic, however, aggressive QE was intended to stabilize the economy and was not neutralized, so the Fed’s balance sheet and the money supply expanded dramatically. A surge in inflation followed.

Rates and Monetary Policy

The IOR regime severs the connection between overnight rates and monetary policy, while artificially fixing the price of reserves. There is little interbank borrowing of reserves under this “ample reserves” policy. But if there is little or no volume, what’s the true level of the Fed funds rate? Some critics (like Wesbury) claim it’s basically made up by the Fed! In any case, there is no longer any real connection between the fed funds rate and the tenor of monetary policy.

Instead, the rate paid to banks on reserves essentially sets a floor on short-term interest rates. And whenever the Fed seeks to tighten policy via IOR rate actions, it faces a potential loss on its interest spread. That represents a conflict of interest for Fed policymaking.

Sumner dislikes the IOR arrangement because, he say, it reinforces the false notion that interest rates are key to understanding monetary policy. For example, higher short-term rates are not always consistent with lower inflation. Sumner prefers controlling the monetary base as a means of targeting the level of nominal GDP, allowing interest rates to signal reserve scarcity. All of that is out of the question as long as the Fed is manipulating the IOR rate.

The Fed As Treasury Lapdog

With IOR and ample reserves, the Fed’s management of a huge portfolio of securities puts it right in the middle of the debt market across a range of maturities. As implied above, that distorts pricing and creates tension between fiscal policy and “independent” monetary policy. Such tension is especially troubling given ongoing, massive federal deficits and increasing Administration pressure on the Fed to reduce rates.

Of course, when the Fed engages in QE, or actively turns over and replaces its holdings of maturing Treasuries with new ones, it is monetizing deficits and creating inflationary pressure. It’s one kind of money printing, the mechanism by which an inflation tax is traditionally understood to reduce the real value of federal debt.

The IOR monetary regime is not the first time the Fed has intervened in the debt markets at longer maturities. In 1961, the Fed ran “Operation Twist”, selling short-term Treasuries and buying long-term Treasuries in an effort to reduce long-term rates and stimulate economic activity. However, the operation did not result in an increase in the Fed’s balance sheet holdings and cannot be interpreted as debt monetization.

Fed Adventurism

The Fed earned positive net interest income from 2008-2023, enabling it to turn over profits to the Treasury. This had a negative effect on federal deficits. However, some contend that the Fed’s net interest income over those years fostered mission creep. Wesbury notes that the Fed dabbled in “… research on climate change, lead water pipes and all kinds of other issues like ‘inequality’ and ‘racism.’” These topics are far afield of the essential functions of a central bank, monetary authority, or bank regulator. One can hope that keeping the Fed on a tight budgetary leash by ending the IOR monetary regime would limit this kind of adventurism.

A Contrary View

John Cochrane insists that IOR is a “lovely innovation”. In fact, he wonders whether the opposition to IOR is grounded in nostalgic, Trumpian hankering for zero interest rates. Cochrane also asserts that IOR is “usually” costless because longer-term rates on the Fed’s portfolio tend to exceed the short-term rate earned on reserves. That’s not true at the moment, of course, and the value of securities in the Fed’s portfolio tanked when interest rates rose. The Fed treats the shortfall in net interest as an increment to a “deferred asset”, but the negative profit, in the interim, must be met by taxpayers (who would normally benefit from the Fed’s profit) or printing money. The Fed shoulders ongoing interest-rate risk, freeing banks of the same to the extent that they hold reserves. Again, this subsidy has a real cost.

I’m surprised that Cochrane doesn’t see the strong potential for monetary lapdoggery under the IOR regime. Sure, the Fed can always print money and load up on new issues of Treasury debt. But IOR and an ongoing “quantitative” portfolio create an institutional bias toward supporting fiscal incontinence.

I’m also surprised that Cochrane would characterize an attempt to end IOR as easier monetary policy. Such a change would be accompanied by an unwinding of the Fed’s mammoth portfolio (QT). That might or might not mean tighter policy, on balance. Such an unwinding would be neutralized by lower demand for bank reserves and a lighter regulatory touch, and it should probably be phased in over several years.

Conclusion

Norbert Michel summarizes the problems created by IOR (the chart at the top of this post is from Michel). Here is a series of bullet points from his December testimony before the Senate Homeland Security and Governmental Affairs Committee (no quote marks below, as I paraphrase his elaborations):

  • The economic cost of the Fed’s losses is high. Periodic or even systemic failures to turn profits over to the Treasury means more debt, taxes, or inflation.
  • The IOR framework creates a conflict of interest with the Fed’s mandate to stabilize prices. The IOR rate set by the Fed has an impact on its profitability, which can be inconsistent with sound monetary policy actions.
  • The IOR system facilitates government support for the private financial sector. Banks get a risk-free return and the Fed acquiesces to bearing rate risk.
  • More accessible money spigot. The Fed can buy and hold Treasury debt, helping to fund burgeoning deficits, while paying banks to hold the extra cash that creates.

The money spigot enables wasteful expansion of government. Unfortunately, far too many partisans are under the delusion that more government is the solution to every problem, rather than the root cause of so much dysfunction. And of course advocates of so-called Modern Monetary Theory are all for printing the money needed to bring about the “warmth of collectivism”.

The Fed Tiptoes Through Lags and an Endless Fiscal Thicket

04 Wednesday Sep 2024

Posted by in Inflation, Monetary Policy

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The late, great Milton Friedman said monetary policy has “long and variable lags” in its effect on the economy. Easy money might not spark an inflation in goods prices for two years or more, though the typical lag is thought to be more like 15-20 months. Tight money seems to have similar lags in its effects. Debates surround the division and timing of these effects between inflation and real GDP, and too many remain convinced that a reliable tradeoff exists between inflation and unemployment.

With that preface, where do we stand today? The Fed executed a veritable helicopter drop of cash during the pandemic, in concert with support payments by the Treasury, with predictable inflationary results. It was also, in part, an accommodation to supply-side pressures. Then the tightening of policy began in the spring of 2022. How will the timing and strength of these shifting policies ultimately play out, as well as the impact of expectations regarding future policy moves?

Help On the Way?

Federal Reserve Chairman Jerome Powell and the Fed’s Open Market Committee (FOMC) are now poised to ease policy after three-plus years of a tighter policy stance. The FOMC is widely expected to cut its short-term interest rate target by a quarter point at the next FOMC on September 17-18. There is an outside chance that the Fed will cut the target by a half point, depending on the strength of new data to be released over the next couple of weeks. In particular, this Friday’s employment report looms large.

What sometimes goes unacknowledged is that the Fed will be following market rates downward, not leading them. The chart below shows the steep drop in the one-year Treasury yield over the past couple of months. Other rates have declined as well. Granted, longer rates are determined in large part by expectations of future short-term rates over which the Fed has more control.

And yet the softening of market rates may well be a signal of weaker economic activity. There is certainly concern among investors that a failure by the Fed to ease policy might jeopardize the much hoped-for “soft landing”. The lagged effects of the Fed’s tighter policy stance may drag on, with damage to the real economy and the labor market. Indeed, some assert that a recession remains a strong possibility (and see here), and the manufacturing sector has been in a state of contraction for five months.

On the other hand, the Fed has fallen short of its 2% inflation goal. The core PCE deflator, the Fed’s preferred inflation gauge, was up 2.6% for the year ending in July. Some observers fear that easing policy prematurely will lead to a new acceleration of inflation.

Powell Gives the Nod

Nevertheless, markets were relieved when Jerome Powell, in his recent speech in Jackson Hole, Wyoming, indicated his determination that a shift in policy was appropriate. From Bloomberg:

“Federal Reserve Chair Jerome Powell said ‘the time has come’ for the central bank to start cutting interest rates.

“Powell’s comments cemented expectations for a rate cut at the central bank’s next gathering in September. The Fed chief said the cooling of the labor market is ‘unmistakable,’ adding, ‘We do not seek or welcome further cooling in labor market conditions.’ Powell also said his confidence has grown that inflation is on a ‘sustainable path’ back to the Fed’s goal of 2%.“

The “sustainable path back to … 2%” might imply a view inside Fed that policy will remain somewhat restrictive even after a quarter or half-point rate cut in September. Or perhaps the “sustainable path” has to do with the aforementioned lags, which might continue to be operative regardless of any immediate change in policy. The feasibility of a “soft landing” depends on whether policy is indeed still restrictive or on how benign those lagged effects turn out to be. But if we take the lags seriously, an easing of policy wouldn’t have real economic force for perhaps 15 months. Still, the market puts great hope in the salutary effects of a move by the Fed to ease policy.

Big Balance Sheet

It can be argued that the Fed already took a step toward easing policy in May when it reduced the rate at which it was allowing runoff in its portfolio of Treasury and mortgage-backed securities. Prior to that, it had been redeeming $95 billion of maturing securities a month. The new runoff amount is $60 billion per month. Unless neutralized in other ways, the runoff has a contractionary effect on bank reserves and the money supply. It is known as “quantitative tightening” (QT). but then the May announcement was a de facto easing in the degree of QT.

Thus far, the total reduction in the Fed’s portfolio has amounted to only $1.7 trillion from the original high-water mark of $8.9 trillion. Here is a chart showing the recent evolution in the size of the Fed’s securities holdings.

The Fed’s current balance sheet of $7.2 trillion is gigantic by historical standards. It’s reasonable to ask why the Fed considers what we have now to be a more “normalized” portfolio, and whether its size (and correspondingly, the money supply) represents potential “dry tinder” for future inflation. It remains to be seen whether the Fed will further pare the rate of portfolio runoff in the months ahead.

Money growth had been running negative for roughly a year and a half, but it edged closer to zero in late 2023 before accelerating to a slow, positive rate a few months into 2024. The timing didn’t exactly correspond to the Fed’s slowing of portfolio runoff. Nevertheless, the Fed’s strong preference is to supply the banking system with “ample reserves”, and reserves drive money growth. Thus, the Fed’s reaction to conditions in the market for reserves was a factor allowing money growth to accelerate.

A Cut Too Soon?

A rate cut later this month will make reserves still more ample and support additional money growth. And again, this will be an effort to mediate the negative impact of earlier policy tightness, but the effect of this move on the economy will be subject to similar lags.

A danger is that the Fed might be easing too soon, so that inflation will fail to taper to the 2% goal and possibly accelerate again. And perhaps policy was not quite as tight as it needed to be to achieve the 2% goal. Now, new supply bottlenecks are cropping up, including a near shutdown of shipping through the Suez Canal and a potential strike by east coast dockworkers.

Fiscal Incontinence

An even greater threat now, and in the years ahead, is the massive pressure placed on the economy and the Fed by excessive federal spending and Treasury borrowing. The growth of federal debt over the 12 months ending in July was almost 10%. Total federal debt stands at about $35 trillion. According to the Congressional Budget Office (CBO) projections, federal debt held by the public will be almost $28 trillion by the end of 2024 (the rest the public debt is held by the Fed or federal agencies). The CBO also projects that the federal budget deficit will average almost $1.7 trillion annually through 2027 before rising to $2.6 trillion by 2034. That would bring federal debt held by the public to more than $48 trillion.

Inflation is receding ever so slowly for now, but it’s unclear that investors will remain comfortable that growth in the public debt can be paid down by future surpluses. If not, the only way its real value can be reduced is through higher prices. Most observers believe such an inflation requires that the Fed monetize federal debt (buy it from the public with printed money). Tighter credit markets will increase pressure on the Fed to do so, but the growing debt burden is likely to exert upward pressure on the prices of goods with or without accommodation by the Fed.

Hard, Soft, Or Aborted Landing?

Some economists are convinced that the Fed has successfully engineered a “soft landing”. I might have to eat some crow…. I felt that a “hard landing” was inevitable from the start of this tightening phase. Even now I would not discount the possibility of a recession late this year or in early 2025. And perhaps we’ll get no “landing” at all. The Fed’s expected policy shift together with the fiscal outlook could presage not just a failure to get inflation down to the Fed’s 2% target, but a subsequent resurgence in price inflation.

“Hard Landing” Is Often Cost of Fixing Inflationary Policy Mistakes

05 Wednesday Oct 2022

Posted by in Inflation, Monetary Policy

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The debate over the Federal Reserve’s policy stance has undergone an interesting but understandable shift, though I disagree with the “new” sentiment. For the better part of this year, the consensus was that the Fed waited too long and was too dovish about tightening monetary policy, and I agree. Inflation ran at rates far in excess of the Fed’s target, but the necessary correction was delayed and weak at the start. This violated the necessary symmetry of a legitimate inflation-targeting regime under which the Fed claims to operate, and it fostered demand-side pressure on prices while risking embedded expectations of higher prices. The Fed was said to be “behind the curve”.

Punch Bowl Resentment

The past few weeks have seen equity markets tank amid rising interest rates and growing fears of recession. This brought forth a chorus of panicked analysts. Bloomberg has a pretty good take on the shift. Hopes from some economists for a “soft landing” notwithstanding, no one should have imagined that tighter monetary policy would be without risk of an economic downturn. At least the Fed has committed to a more aggressive policy with respect to price stability, which is one of its key mandates. To be clear, however, it would be better if we could always avoid “hard landings”, but the best way to do that is to minimize over-stimulation by following stable policy rules.

Price Trends

Some of the new criticism of the Fed’s tightening is related to a perceived change in inflation signals, and there is obvious logic to that point of view. But have prices really peaked or started to reverse? Economist Jeremy Siegel thinks signs point to lower inflation and believes the Fed is being too aggressive. He cites a series of recent inflation indicators that have been lower in the past month. Certainly a number of commodity prices are generally lower than in the spring, but commodity indices remain well above their year-ago levels and there are new worries about the direction of oil prices, given OPEC’s decision this week to cut production.

Central trends in consumer prices show that there is a threat of inflation that may be fairly resistant to economic weakness and Fed actions, as the following chart demonstrates:

Overall CPI growth stopped accelerating after June, and it wasn’t just moderation in oil prices that held it back (and that moderation might soon reverse). Growth of the Core CPI, which excludes food and energy prices, stopped accelerating a bit earlier, but growth in the CPI and the Core CPI are still running above 8% and 6%, respectively. More worrisome is the continued upward trend in more central measures of CPI growth. Growth in the median component of the CPI continues to accelerate, as has the so-called “Trimmed CPI”, which excludes the most extreme sets of high and low growth components. The response of those central measures lagged behind the overall CPI, but it means there is still inflationary momentum in the economy. There is a substantial risk that expectations of a more permanent inflation are becoming embedded in expectations, and therefore in price and wage setting, including long-term contracts.

The Fed pays more attention to a measure of prices called the Personal Consumption Expenditures (PCE) deflator. Unlike the CPI, the PCE deflator accounts for changes in the composition of a typical “basket” of goods and services. In particular, the Fed focuses most closely on the Core PCE deflator, which excludes food and energy prices. Inflation in the PCE deflator is lower than the CPI, in large part because consumers actively substitute away from products with larger price increases. However, the recent story is similar for these two indices:

Both overall PCE inflation and Core PCE inflation stopped accelerating a few months ago, but growth in the median PCE component has continued to increase. This central measure of inflation still has upward momentum. Again, this raises the prospect that inflationary forces remain strong, and that higher and more widespread expected inflation might make the trend more difficult for the Fed to rein in.

That leaves the Fed little choice if it hopes to bring inflation back down to its target level. It’s really a only a choice of whether to do it faster or slower. One big qualification is that the Fed can’t do much about supply shortfalls, which have been a source of price pressure since the start of the rebound from the pandemic. However, demand pressures have been present since the acceleration in price growth began in earnest in early 2021. At this point, it appears that they are driving the larger part of inflation.

The following chart shows share decompositions for growth in both the “headline” PCE deflator and the Core PCE deflator. Actual inflation rates are NOT shown in these charts. Focus only on the bolder colored bars. (The lighter bars represent estimates having less precision.) Red represents “supply-side” factors contributing to changes in the PCE deflator, while blue summarizes “demand-side” factors. This division is based on a number of assumptions (methodological source at the link), but there is no question that demand has contributed strongly to price pressures. At least that gives a sense about how much of the inflation can be addressed by actions the Fed might take.

I mentioned the role of expectations in laying the groundwork for more permanent inflation. Expected inflation not only becomes embedded in pricing decisions: it also leads to accelerated buying. So expectations of inflation become a self-fulfilling prophesy that manifests on both the supply side and the demand-side. Firms are planning to raise prices in 2023 because input prices are expected to continue rising. In terms of the charts above, however, I suspect this phenomenon is likely to appear in the “ambiguous” category, as it’s not clear that the counting method can discern the impacts of expectations.

What’s a Central Bank To Do?

Has the Fed become too hawkish as inflation accelerated this year while proving to be more persistent than expected? One way to look at that question is to ask whether real interest rates are still conducive to excessive rate-sensitive demand. With PCE inflation running at 6 – 7% and Treasury yields below 4%, real returns are still negative. That’s hardly seems like a prescription for taming inflation, or “hawkish”. Rate increases, however, are not the most reliable guide to the tenor of monetary policy. As both John Cochrane and Scott Sumner point out, interest rate increases are NOT always accompanied by slower money growth or slowing inflation!

However, Cochrane has demonstrated elsewhere that it’s possible the Fed was on the right track with its earlier dovish response, and that price pressures might abate without aggressive action. I’m skeptical to say the least, and continuing fiscal profligacy won’t help in that regard.

The Policy Instrument That Matters

Ultimately, the best indicator that policy has tightened is the dramatic slowdown (and declines) in the growth of the monetary aggregates. The three charts below show five years of year-over-year growth in two monetary measures: the monetary base (bank reserves plus currency in circulation), and M2 (checking, saving, money market accounts plus currency).

Growth of these aggregates slowed sharply in 2021 after the Fed’s aggressive moves to ease liquidity during the first year of the pandemic. The monetary base and M2 growth have slowed much more in 2022 as the realization took hold that inflation was not transitory, as had been hoped. Changes in the growth of the money stock takes time to influence economic activity and inflation, but perhaps the effects have already begun, or probably will in earnest during the first half of 2023.

The Protuberant Balance Sheet

Since June, the Fed has also taken steps to reduce the size of its bloated balance sheet. In other words, it is allowing its large holdings of U.S. Treasuries and Agency Mortgage-Backed Securities to shrink. These securities were acquired during rounds of so-called quantitative easing (QE), which were a major contributor to the money growth in 2020 that left us where we are today. The securities holdings were about $8.5 trillion in May and now stand at roughly $8.2 trillion. Allowing the portfolio to run-off reduces bank reserves and liquidity. The process was accelerated in September, but there is increasing tension among analysts that this quantitative tightening will cause disruptions in financial markets and ultimately the real economy, There is no question that reducing the size of the balance sheet is contractionary, but that is another necessary step toward reducing the rate of inflation.

The Federal Spigot

The federal government is not making the Fed’s job any easier. The energy shortages now afflicting markets are largely the fault of misguided federal policy restricting supplies, with an assist from Russian aggression. Importantly, however, heavy borrowing by the U.S. Treasury continues with no end in sight. This puts even more pressure on financial markets, especially when such ongoing profligacy leaves little question that the debt won’t ever be repaid out of future budget surpluses. The only way the government’s long-term budget constraint can be preserved is if the real value of that debt is bid downward. That’s where the so-called inflation tax comes in, and however implicit, it is indeed a tax on the public.

Don’t Dismiss the Real Costs of Inflation

Inflation is a costly process, especially when it erodes real wages. It takes its greatest toll on the poor. It penalizes holders of nominal assets, like cash, savings accounts, and non-indexed debt. It creates a high degree of uncertainty in interpreting price signals, which ordinarily carry information to which resource flows respond. That means it confounds the efficient allocation of resources, costing all of us in our roles as consumers and producers. The longer it continues, the more it erodes our economy’s ability to enhance well being, not to mention the instability it creates in the political environment.

Imminent Recession?

So far there are only limited signs of a recession. Granted, real GDP declined in both the first and second quarters of this year, but many reject that standard as overly broad for calling a recession. Moreover, consumer spending held up fairly well. Employment statistics have remained solid, though we’ll get an update on those this Friday. Nevertheless, payroll gains have held up and the unemployment rate edged up to a still-low 3.7% in August.

Those are backward-looking signs, however. The financial markets have been signaling recession via the inverted yield curve, which is a pretty reliable guide. The weak stock market has taken a bite out of wealth, which is likely to mean weaker demand for goods. In addition to energy-supply shocks, the strong dollar makes many internationally-traded commodities very costly overseas, which places the global economy at risk. Moreover, consumers have run-down their savings to some extent, corporate earnings estimates have been trimmed, and the housing market has weakened considerably with higher mortgage rates. Another recent sign of weakness was a soft report on manufacturing growth in September.

Deliver the Medicine

The Fed must remain on course. At least it has pretensions of regaining credibility for its inflation targeting regime, and ultimately it must act in a symmetric way when inflation overshoots its target, and it has. It’s not clear how far the Fed will have to go to squeeze demand-side inflation down to a modest level. It should also be noted that as long as supply-side pressures remain, it might be impossible for the Fed to engineer a reduction of inflation to as low as its 2% target. Therefore, it must always bear supply factors in mind to avoid over-contraction.

As to raising the short-term interest rates the Fed controls, we can hope we’re well beyond the halfway point. Reductions in the Fed’s balance sheet will continue in an effort to tighten liquidity and to provide more long-term flexibility in conducting operations, and until bank reserves threaten to fall below the Fed’s so-called “ample reserves” criterion, which is intended to give banks the wherewithal to absorb small shocks. Signs that inflationary pressures are abating is a minimum requirement for laying off the brakes. Clear signs of recession would also lead to more gradual moves or possibly a reversal. But again, demand-side inflation is not likely to ease very much without at least a mild recession.