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By Jean Yung
     WASHINGTON (MNI) - The Federal Reserve's plan to conclude asset runoffs
this year would still leave its balance sheet at levels that expose the central
bank to potential political pressure, St. Louis Fed economist David Andolfatto
told MNI, calling for the introduction of a standing repo facility as a way to
reduce banks' demand for reserves.
     Policymakers aim to whittle down the Fed's balance sheet to the minimum
level of bank reserves needed to control interest rates effectively. Market
participants project that level to be in the $1 trillion range, much higher than
their pre-crisis average $20 billion to $30 billion, driven by the demands of
new regulations on bank liquidity and orderly resolution.
     Such high levels of reserves could mean that the Fed might be forced to
make large interest payments to domestic and foreign banks if the central bank
significantly raises the interest rate on excess reserves, a situation
Andolfatto said could be "political dynamite."
     "We're subsidizing these large foreign banks by paying a high interest rate
on large reserves. This interest expense is costing the Treasury money. Why do
we want to do this?" he said. "If we could go back to $20 billion in reserves,
the optics look a lot better for the Fed," he said in an interview Thursday.
     --DEMAND FOR RESERVES
     A standing overnight repurchase facility allowing banks to swap Treasuries
for reserves at any time would give banks more confidence that they could buy
government debt - which offers a higher return than interest on reserves --
without fear of being unable to meet cash requirements in a hurry, Andolfatto
said. Demand for reserves would "decline substantially."
     "It will be a foolproof way of adjudicating the minimum level of reserves
needed," he said. "You wouldn't have to guesstimate like the New York Fed is
doing by surveying banks."
     Commercial banks, the U.S. Treasury and foreign central banks earn interest
on balances kept at the Fed. The IOER, currently set at 2.40%, is a key tool
used by the Fed to steer its benchmark federal funds rate.
     Eight of the largest U.S. banks may want to hold $784 billion in reserves
to cover emergency liquidity needs, according to a recent New York Fed analysis.
If they were to substitute Treasuries for these reserves, then the minimum level
needed for the Fed to implement monetary policy effectively "would be closer to
$200 billion," Andolfatto said.
     "It only makes sense. Why would banks hold low-interest reserves when they
could potentially be holding higher yielding Treasuries that are just as safe
and can be liquidated?" he said.
     The repo facility, whose rate would be set by the Fed, would also act as a
ceiling on short-term interest rates. According to the minutes of the latest
FOMC meeting, policymakers would support the use of such a tool.
     "A couple of participants suggested that a ceiling facility to mitigate
temporary unexpected pressures in reserve markets could play a useful role in
supporting policy implementation at lower levels of reserves," the January
meeting minutes said.
--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com
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