The Fed’s QE1 was designed to restore solvency to banks. It bought mortgage backed securities and other assets from banks and paid for them by crediting checking accounts banks hold at the Fed. In the Fed’s estimation, it took $1.6 trillion of MBS off banks’ books to restore solvency. The Fed realizes, just as the rest of us do, the price inflationary potential of $1.6 trillion of excess reserves. (The ratio of M2 to require reserves is 100 to 1.) So, the Fed must control how banks use these excess reserves. Otherwise, when banks return to the normal process of issuing fiduciary media and creating credit on top of these reserves, price inflation will explode. The Fed thinks it can control the extent to which banks lend on top of their excess reserves (thereby converting them to required reserves) by paying banks interest on ER. If banks start to create too much credit, the Fed will raise the interest rate on ER.
In short, to save the banks and bailout the holders of MBS, the Fed has created the potential for massive price inflation. Now it must control how that potential gets actualized.
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