The central bank is created by the government, it operates under rules and laws created and changed by the government, the leaders are appointed by the government, it is given governmental regulatory powers over banks, and at least in the US case the profits go to the government. For the rest of this article, try to think of the Federal Reserve as just part of the government. So if a bank gives their money to the Fed and earns interest or gives it to the Treasury and earns interest, just think of it as giving it to the government and earning interest.
The bank excess reserves at the Fed used to be tiny amounts, not earning interest, just part of the money supply. In Oct 2008 the Federal Reserve started paying interest on excess reserves and the size has shot up since then. People understand that this money "just sitting in the banks and not lent out" is not inflationary. It has let the Fed print lots of money without causing lots of inflation, so far.
The Fed has put out $2 trillion in new money and sucked in $2 trillion at about the same time by paying interest on excess reserves. The net result is little inflation, so far.
I think the best way to think of excess reserves is as part of the national debt. Since it is owed by a government agency to something outside government, and earns interest, it really is like a government debt. Paying interest on excess reserves keeps some money off the street, just like short term government debt, and so reduces inflationary pressure.
When excess reserves did not pay any interest it was correct to count them as part of the money supply, which does not pay interest. When they are paying interest they are like government debt and should be counted as such.
If you imagine a big black box around both the Treasury and the Fed, what goes on outside the box, how much money is out of circulation, the interest earned, lack of inflationary pressure, is no different if when money is loaned into the box it is recorded in the Treasury as bonds or in the Fed as excess reserves.
The monetary base has a big strange jump up when they start paying interest on excess reserves.
However, if we subtract excess reserves from the monetary base then it does not look like anything peculiar is going on. This could help explain why there has been little price inflation so far.
If we add excess reserves to the national debt held by the public, it is then growing even faster and is even less sustainable.
I view this as a clever trick to let the government print almost $2 trillion that does not seem inflationary, so far, but also does not make people worry about a larger national debt. It is like they are hiding a $2 trillion debt right out in the open. It is an amazing magic trick, but it is just a trick. It does not make anything better.
The near term inflationary pressure is really lower than one would expect from just looking at the monetary base. However, the hyperinflation risk is higher than one would think from just looking at the official debt and deficit numbers. As far as the size of the potential money flood in hyperinflation, it is like the short term US debt is $2 trillion higher than people think. The threshold for hyperinflation has been found to be debt/GDP of 80%. If we include the excess reserves as part of the debt then the US debt/GDP went from 40% to nearly over 80% just since this crisis started. The upward trend is very steep.
Here is debt held by the public plus excess reserves compared to CPI:
Next it is interesting to plot gold and the excess reserves plus debt held by public:
Now for some wild speculation. Paulson and Bernanke had a secret meeting the month before the Fed started paying interest on excess reserves. At that time Paulson was telling congressmen that if they did not do what he wanted there would be martial law. I can imagine Paulson telling Bernanke that the government needed more money and also needed the Fed to help fight inflation, so the Fed should pay interest on excess reserves to suck back off the street some of the extra money the government would be spending. Paulson probably understood that it was a trick to hide government debt. Bernanke might have been in on the trick or he might have been conned.
Updated on 8/29/14 to only use debt held by the public and never total debt in the graphs. User on seeking alpha pointed out that it is double counting to count both a bond the Fed is holding and the excess reserves it created to buy that bond.