MNI Interview: Ex-Fed English Sees Balance Sheet Battle Ahead

By Pedro Nicolaci da Costa

     WASHINGTON (MNI) - The U. S. Federal Reserve should clarify how quickly and

how far it plans to unwind its massive balance sheet as soon as possible to

avoid any market disruptions or surprises, a former top Fed official told MNI in

an interview.

     William English, a career Fed economist and the board of governors'

director for monetary affairs between 2010 and 2015, cited an unusual recent

spike in the federal funds rate toward the interest the Fed pays on bank

reserves, which is supposed to act as an interest rate ceiling. He says the

Fed's massive bond-buying program may prove harder to unwind than many central

bank officials anticipate.

     "They do need to say something before long so that the public and market

participants have time to think about it and plan," English, now a professor at

the Yale School of Management, said. 

     "My sense is they well may end up having a bigger balance sheet than they

thought if they end up with a floor system - and my guess is they will stick

with the floor system," he added.

     --FOMC DEBATE

     MNI reported Nov. 1 that the Fed is debating at its FOMC meeting this week

whether to keep the current "floor system" of interest rates that allows for a

large amount of reserves to continue circulating around the banking system while

the central bank drains liquidity by paying interest on bank reserves - a

mechanism granted by Congress during the financial crisis.

     Some policymakers worry a large balance sheet might distort financial

markets and could raise political pressure on the central bank to help troubled

industries or pockets of finance if it is seen as sitting on a pile of money.

     Yet English said the Fed's earlier conception of returning to a bare bones

balance sheet with the minimum amount of bank reserves required for the

financial system to function has been dampened by the benign practical

experience of operating under a system of abundant reserves.

     So how large will the balance sheet end up being? The Fed's total asset

portfolio peaked at $4.5 trillion last year and has since slipped to around $4.1

trillion since the central bank stopped reinvesting the principal of maturing

securities back into the bond market. Policymakers had originally talked about a

large reduction, not the pre-crisis level of around $800 billion but potentially

as low as $2 trillion.

     English said he prefers to think of the amount of outstanding reserves

rather than the overall balance sheet size. He thinks bank reserve balances

parked at the Fed, currently at $1.8 trillion, could dip down to $1 trillion but

not much lower. That would likely leave the Fed with a balance sheet well over

$3 trillion in size. The implications for monetary policy are not entirely

clear, which means policymakers will need to continue studying their policy

framework in real time.

     --STEADY FED

     As for near-term policy prospects, English expects the Fed to keep raising

interest rates gradually in December and into next year, when it will have more

insight into whether the recent burst of economic growth, led by tax cuts and

large budget deficit, will be fleeting or more sustainable.

     "The economy has a lot of momentum," he said. "Fiscal policy has provided a

boost this year and business and consumer confidence have recovered" from their

post-Great Recession doldrums. "They'll have to slow things down some [later]

but for now I think everything stays in the current track."

     The Fed has been raising interest rates at every other meeting, or once a

quarter, for about two years, having raised the benchmark federal funds rate,

which remained at zero for seven years following the financial crisis, to a

range of 2% to 2.25%.

--MNI London Bureau; tel: +44 203-586-2223; email: david.robinson@marketnews.com

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