MNI: Fed’s George Wants Major Balance Sheet Reduction

The Federal Reserve should not shy away from a major reduction in its USD8.7 trillion balance sheet as it removes monetary stimulus from the economy, Kansas City Fed President Esther George said Monday.

“While it might be tempting to err on the side of caution, the potential costs associated with an excessively large balance sheet should not be ignored,” George said in prepared remarks to the Economic Club of Indiana.

These include distortions to the financial system from the Fed’s large presence in the Treasury and MBS markets, reduced policy space for a future downturn and a possible threat to Fed independence.

“A large balance sheet has the potential to intertwine fiscal and monetary policy in the public’s eyes and could unintentionally pose risks to the Fed’s independence and authority,” she said. “In a rising rate environment, this risk could become more apparent as interest paid on the large stock of reserve liabilities grows.”

The Fed last week signaled it will likely start raising interest rates in March, but also laid out basic principles for balance sheet reduction. George suggested the devil will be in the details, which have yet to be ironed out.

“What we do on the balance sheet will likely affect the path of policy rates and vice versa. For example, more aggressive action on the balance sheet could allow for a shallower path for the policy rate,” George said.

“Alternatively, combining a relatively steep path of rate increases with relatively modest reductions in the balance sheet could flatten the yield curve and distort incentives for private sector intermediation, especially for community banks, or risk greater economic and financial fragility by prompting reach-for-yield behavior from long-duration investors.”

George said she’s cautiously optimistic that supply kinks that have been driving up inflation are beginning to ease, if only gradually.

“There are indications that the worst has passed as shipping rates have peaked and port backlogs are being cleared,” she said. “Still, global supply networks continue to face risks, particularly those going through China where a zero-Covid policy and strict lockdowns are running up against the highly transmissible Omicron variant.”