MNI ANALYSIS: FOMC Comfortable With Larger Balance Sheet

By Jean Yung

     WASHINGTON (MNI) - Federal Reserve officials are in the midst of a vigorous

debate over the future of the operating framework for controlling short-term

interest rates, but they agree on one thing: balance sheet wind-down still has a

way to run.

     The minutes of the November Federal Open Market Committee meeting, released

Thursday, showed officials weighing the pros and cons of keeping the so-called

"floor" system, adopted after the 2008 financial crisis, now that monetary

policy is normalizing.

     The current regime requires substantially higher levels of excess reserves

than before the financial crisis, and the Fed is already a year into a program

to slowly shed assets. But, as the minutes revealed, feedback from bank contacts

as well as internal research have given policymakers greater confidence that

reserve levels are still well above a level that would necessitate a return to

the pre-crisis system.

     "Participants noted that the level of reserve balances required to remain

in a regime where rate control does not entail active management of the supply

of reserves was quite uncertain," the minutes said, "but they thought that

reserve supply could be reduced substantially below its current level while

remaining in such a regime."

     --MAGIC NUMBER $1 TRILLION

     In the wake of new banking regulations and other shifts in market dynamics,

officials are seeking to understand banks' demand for reserves under various

scenarios.

     Even as money market rates climbed close to the Fed's administered rate,

the interest paid on banks' excess reserves, in recent months, banks told the

Fed they would still be willing to maintain "substantially higher" levels of

balances than before the crisis, the minutes said.

     In a survey of 51 banks that together held roughly two-thirds of total

reserve balances in the banking system in August, respondents identified $600

billion, or about half of current holdings, as the lowest level of reserve

balances they would feel comfortable holding, the Fed said.

     Extrapolating that to the banks not included in the survey would point to a

minimum reserves level of roughly $1 trillion, matching the figure Fed sources

identified to MNI earlier this month as the internal working estimate for a

normalized balance sheet.

     The Fed trims its bond holdings by about $50 billion a month. With excess

reserves currently standing at around $1.6 trillion, another 13 months of

drawdown would whittle reserves down to around $1 trillion.

     --REGIME DECISION

     The FOMC laid out a number of reasons to keep the floor system, hinting

that officials may be close to a decision.

     The current framework has shown itself to be effective and workable in the

extreme conditions of a crisis and through several rounds of large-scale asset

purchases to stimulate the economy, the minutes said.

     The Fed's uncertainty over banks' demand for reserves also presents a

drawback for a return to the pre-crisis reserve-scarce regime as it would

undermine the Fed's efforts to target a specific interest rate. An

abundant-reserves framework would not rely on the Fed actively draining or

adding reserves on a daily basis, because changes would be too small as a

proportion of the total to significantly affect interest rates.

     Banks indicated in the Fed's survey that they might reduce their views of

the lowest levels of reserves they were comfortable holding only modestly from

current levels if money market rates rose above IOER, the minutes said. Half of

respondents said even if short-term rates rose 50 basis points above IOER, they

would not cut their holdings.

     That suggests both policymakers and markets are comfortable with a larger

balance sheet.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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