MNI INTERVIEW: Fed Should Keep Plan to Shrink Balance Sheet

By Jean Yung

     WASHINGTON (MNI) - The Federal Reserve should continue running down its

balance sheet through September even if it cuts interest rates before then,

Philadelphia Fed economist Roc Armenter said in an interview.

     Adjustments to the federal funds rate remain the primary means of adjusting

the monetary policy stance, so "I do not see any need to review or revise the

balance sheet policy in the short term," he told MNI last week.

     "I'm in favor to stay on course, finalize asset redemptions in September,

and start the second stage of the program of keeping the overall size of the

balance sheet constant while letting reserves decline slowly with growth in

currency and other non-reserve liabilities," he said.

     Powell on Wednesday reiterated that the FOMC is prepared to adjust its

balance sheet normalization plan if warranted, fueling speculation that

policymakers will end asset runoffs a couple months earlier than planned if it

lowers rates this month.

     --RESERVES AMPLE

     Excess bank reserves in the system remain ample, despite a rise in observed

volatility in the effective fed funds rate in recent months, Armenter said.

Nearly two years of so-called quantitative tightening has trimmed bank reserves

to around $1.5 trillion from a post-crisis high of $2.8 trillion.

     Policymakers aim to keep reserves plentiful to ensure control over its

benchmark interest rate. The Fed's benchmark short-term policy rate has

fluctuated by 1 to 2 basis points from day to day since spring and noticeably

more than in years past. The dispersion of fed funds trades on an intraday basis

has risen to as much as 4 basis points from 1 basis point previously.

     Armenter called the increase in volatility and dispersion "quite positive,

even somewhat surprising" and attributes it in part to the FOMC's narrowing of

the spread between the Fed's administered rates, the interest paid on excess

reserves and overnight reverse repo rate, to 10 basis points from 25 points a

year ago.

     "The market is showing resilience," he said. Another knock-on effect has

been that the fed funds rate has become more sensitive to repo rates.

     "Secured and unsecured rates are a little bit more in sync day to day," he

said. As the IOER-ON RRP spread has shrunk, "some parties look at secured rates

to see if they can substitute their unsecured positions."

     Another reason for the increase in volatility is the fed funds market has

become a bit more sensitive to idiosyncratic aspects of trades by particular

institutions during any given day, he said.

     "I don't see heightened sensitivity to the aggregate supply of reserves in

the system even though the level of reserves has been reduced quite a bit," he

said.

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

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