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By Jean Yung
     WASHINGTON (MNI) - The reduction in the size of the Federal Reserve's
balance sheet may be pressuring the fed funds rate higher, according to research
Wednesday from the Kansas City Federal Reserve which will hand extra ammunition
to those arguing that the Fed's policy normalization is tightening financial
conditions.
     A scarcity in bank reserves "is an important factor in explaining why the
federal funds rate has moved higher relative to the (interest on reserves) rate,
even after accounting for increasing repo rates. These findings suggest that the
funds rate may continue to move higher relative to the IOR rate against a
backdrop of balance sheet normalization and further declines in reserve
balances," senior economist A. Lee Smith wrote in the paper. 
     Kansas City Fed chief Esther George is among the minority within the Fed
who have conceded that its efforts to shed assets acquired during the financial
crisis may have played a role in recent market volatility. Some investors have
argued that so-called "quantitative tightening" should be dialed back in light
of the Fed's wait-and-see stance on policy this spring. 
     The effective fed funds rate has crept higher in recent months and at one
point threatened to breach the upper range of the Fed's target range, prompting
policymakers to develop so-called "ceiling tools" to strengthen their control
over rates. 
     Fed officials have pointed to a rise in short-term secured financing rates
or repo rates and a surfeit of Treasury bill issuance as reasons behind the
higher funds rate. 
     But Smith contends that the large decline in reserve balances over the past
few years may be responsible for the upward drift instead, despite reserves
sitting at substantially higher levels than prior to the financial crisis. 
     "As reserve balances decline, the federal funds rate may continue to move
modestly higher against the IOR rate. Such a rise could necessitate further
implementation adjustments as policymakers continue to learn about the drivers
of the federal funds rate in the Fed's new operating framework," Smith said.
--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com
[TOPICS: MMUFE$,M$U$$$]

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