MNI INTERVIEW: Rates Moves May Prompt Fed Balance Sheet Growth

--Repeating Story Initially Sent at 12:59 ET/16:59 GMT Tuesday

By Jean Yung

     WASHINGTON (MNI) - The rise in the fed funds rate over another key rate

could speed up a resumption of the expansion of the Federal Reserve's balance

sheet, an economist at the Kansas City Fed said in an interview, after the Fed's

benchmark breached the interest it pays on excess reserves for the first time

last week.

     The effective funds rate could rise up to 10 basis points above IOER before

balance sheet normalization concludes, Lee Smith told MNI, adding that the

upward drift is a signal that reserves scarcity is beginning to bind. This could

prompt the Fed to lower IOER further to ensure the fed funds rate remains well

within the target range, or alternatively it could take it as a cue to resume

purchasing securities to keep reserves constant as its liabilities grow.

     While Kansas City Fed President Esther George and others are sympathetic to

Smith's explanation for the rising fed funds rate relative to IOER, other Fed

officials including Chair Jay Powell blame rising Treasury issuances instead.

     The effective fed funds rate traded at 2.41% for three days before

retreating this week to 2.40%, equal to IOER.

     "Even though we're in an abundant reserves regime, there's a clear pattern

over the last several years that declining reserve balances are associated with

upward pressure on the fed funds-IOER spread," Smith said, noting the steady

rise of the effective fed funds rate from roughly 15 basis points below IOER

since 2014, long before the Treasury's borrowing needs surged in the wake of

Trump's fiscal stimulus.

     Last week's uptick in the fed funds rate, though "noteworthy," likely

reflects typical market fluctuations, he added. "But if it persists and if it's

coupled with a couple basis points more of a move, we might be getting to an

inflection point" for the level of reserves needed in the system.

     --REINVESTMENT START

     After calling an end to the reduction of its balance sheet in September,

the FOMC must now determine the point at which it should once again purchase

securities so that reserves remain steady as its liabilities, mainly currency in

circulation, grow.

     Policymakers' tolerance for a wider FFR-IOER spread and rising rate

volatility could play a key role that debate, Smith said.

     If officials prefer to keep the fed funds rate trading near IOER, then

reserve balances could range anywhere from the recent level of $1.6 trillion

down to $1.3 trillion, according to his modeling. If officials are willing to

tolerate a scenario in which the fed funds rate rises 10 basis points above

IOER, then reserves could decline toward a $1 trillion to $1.2 trillion range.

     In the latter case, more technical adjustments to IOER may be needed, and

Smith sees room to cut IOER all the way to the bottom of the target range. "That

would be consistent with the idea that IOER is a floor for the fed funds rate,"

he said.

     --CEILING TOOL

     The creation of so-called ceiling tools would limit volatility in

short-term interest rates as the Fed explores the limits of an abundant reserves

regime, Smith said.

     Fed economists David Andolfatto and Jane Ihrig last month proposed a

standing repo facility as one such tool. It would mirror the Fed's current

overnight reverse repo facility and allow banks to swap Treasury collateral for

reserves on demand.

     Smith endorsed a repo facility as something that would "allow you to probe

more finely the limits of a smaller balance sheet," but added that policymakers

would first need to reach a consensus over its desirability and design.

     "The FOMC would need to decide the footprint it wants to have in repo

markets," Smith said. But, "in some sense if you're going to do it, the time to

do it seems to be sooner rather than later."

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

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