MNI INTERVIEW:Fed Balance Sheet Has Room To Fall-Fed Economist

By Jean Yung

     WASHINGTON (MNI) - The Federal Reserve can likely continue trimming its

balance sheet for at least another year before bank reserves become scarce

enough to impede the implementation of monetary policy, Philadelphia Fed

economist Roc Armenter told MNI in an interview.

     A recent jump in the Fed's benchmark interest rate toward the top of its

target range, which has raised doubts over the sustainability of the U.S.

monetary policy framework, is driven by surging government borrowing and not the

rundown in central bank reserves, Armenter, whose research focuses on the effect

of reserve scarcity on the fed funds market, said.

     The scarce-reserves threshold is likely somewhere above $1 trillion but

still far below the current reserves level of roughly $2 trillion, he said.

"Balance sheet normalization is going as predicted and not particularly fast.

There may be some scenario where repo rates rise by a surprise 5 basis points or

so further that could bring forward the timeline. But if that doesn't happen,

then I think there is at least one year before reserves start to feel scarce."

     It has been the large increase in the supply of Treasury bills this year

that has underpinned a run-up in repo rates and in turn driven the fed funds

rate 8 to 10 bps higher than would otherwise have been the case, he said. But

the Fed's operating framework for controlling overnight money market rates

continues to perform well as reserves decline.

     --FLOOR SYSTEM WORKS

     The rise in the effective federal funds rate - the median short-term rate

at which banks lend to each other - to a level equal to the interest the Fed

pays on excess reserves had led some to argue that its capacity to run down the

balance sheet accumulated during quantitative easing is limited.

     Since the financial crisis, the central bank has used two key tools, IOER

and the overnight reverse repurchase agreement facility, to help steer

short-term interest rates -- an operational framework known as a "floor" system.

     Theoretically, as reserve balances fall below a certain threshold, reserves

scarcity will pressure the overnight interest rate higher. This was the case in

the pre-crisis "corridor" system, which required the Fed to conduct daily open

market operations to inject liquidity.

     But Armenter and other Fed officials argue that reserve levels are still

sufficiently plentiful that rates don't respond much to changes in reserve

levels -- and that the current system is working well. Instead they point to a

$300 billion increase in the supply of Treasuries in the first few months of the

year that pushed short-term repo rates higher and created an attractive

alternative investment opportunity for lenders -- leaving borrowers to compete

for a reduced pool of fed funds.

     --IOER TWEAK

     As the gap between the fed funds rate and the top of the Fed's target range

continues to narrow, another technical adjustment to IOER "is a possibility if

needed," to minimize the risk that the Fed loses control over short-term rates,

Armenter said.

     Investors are looking to the release of the November FOMC meeting minutes

this week for any confirmation of market expectations that the FOMC will lift

IOER by 20 bps in December at the same time that it raises the target range by

25 bps, a tweak policymakers first deployed in June.

     Armenter warned however that at most two more such adjustments would be

"the end of the road," as the spread between IOER and the overnight reverse

repurchase agreement facility would shrink to a mere 10 bps.

     "There's still quite a bit of arbitrage going on in the background, but at

10 bps that's going to be minimal. At that point, either the fed funds market

becomes very thin or the technical adjustment will stop being effective," he

said.

     --ALTERNATE BENCHMARK RATE

     Armenter reckons the Fed could adopt an alternative benchmark rate such as

the Secured Overnight Financing Rate -- the designated successor to LIBOR in the

United States -- in the next few years, a timeline that might surprise

investors.

     Trading volume in the market for bank reserves, already thin, could dry up

further either due to even higher repo rates or reflecting the changing

landscape for federal home loan banks, creating more "noise" in the effective

fed funds rate day-to-day, Armenter said.

     At the same time, regulatory changes have incentivized markets to shift

toward secured trades.

     "We need a definition of what reference rate will be used going forward,

because of the fragility of the fed funds market," he said. Transitioning to a

new policy rate, while not painless, could be easily communicated and smoothly

accomplished, he added.

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

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