MNI INTERVIEW: Fed 'Buffer' Means Larger Balance Sheet

By Jean Yung

     WASHINGTON (MNI) - The Federal Reserve will need to deploy a "generous"

buffer of bank reserves to ensure control over short-term interest rates after

it stabilizes the size of its balance sheet at a lower level, Philadelphia Fed

economist Roc Armenter told MNI in an interview.

     As the Fed moves towards normalizing monetary policy and runs off bonds

accumulated during quantitative easing, the level of reserves held by commercial

banks is drained, as private sector money is diverted into purchases of

securities freed from the central bank's balance sheet. This raises the danger

that sudden large flows of funds into the U.S. Treasury and other nonbank

depositors' accounts -- around major tax deadlines for example -- could suck

reserves below the level at which banks can meet their minimum requirements.

That might force lenders to compete for limited supply and lead to rate spikes.

     To counter these flows, which can exceed $100 billion in a single week,

Armenter suggested it would be prudent to retain a substantial buffer.

     "A number of nonreserve liabilities, namely the Treasury general account

and foreign repo, are larger and way more volatile than they were in the past

and can have swings of hundreds of billions in short periods of time. There is a

sense that there needs to be something to absorb those variations," he said.

     "The natural way to start is with a generous, cautious, prudent buffer. And

if it seems to be enough, see if it can be reduced."

     --END IN SIGHT

     Fed officials may wrap up their balance sheet program with reserves falling

to no less than $1 trillion, according to MNI interviews, suggesting total Fed

assets will be at least $3.5 trillion if not closer to $3.9 trillion by the end

of the normalization process.

     With the balance sheet already whittled down to $4.1 trillion, the FOMC is

close to finalizing its target date to end run-offs, Philadelphia Fed chief Pat

Harker told MNI last week.

     Apart from banks' demand for reserves, the Fed must accommodate rising

demand for U.S. currency, which stands at $1.7 trillion and is expanding at

roughly $0.1 trillion a year, and a group of highly variable nonreserve

liabilities.

     The latter comprise the Treasury account, the foreign repo pool and

deposits from so-called designated financial market utilities, adding up to over

$600 billion. These liabilities are unique in that their size is both large and

volatile -- and largely outside the control of the Fed.

     Flows in and out of these accounts "used to be sterilized with open market

operations in the past, but they were also way smaller back then," Armenter

said. Standard open market operations conducted prior to the financial crisis

were for less than $10 billion, with a maximum size of around $20 billion.

     Under the post-crisis operating framework, "you have to rely on the buffer

to make sure interest rates don't jump on any given day," Armenter said.

     --EVOLVING DEMAND

     Once the buffer is set, policymakers could fine-tune its size by allowing

currency in circulation to displace some of the bank reserves but may still need

to revisit it occasionally, Armenter said.

     Banks' demand for reserves will evolve with changes in financial

regulation, advances in payments technology and trends in liquidity management.

     "I think it is fair to say that some of these factors could move the demand

by hundreds of billions, but would do so only slowly over time," Armenter said.

     Nevertheless, he added, "I suspect we will not be playing with the size of

the buffer day to day. We'll have a number and if needed to revise it over time

as banks get better at monitoring the situation."

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

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