By Michael S. Derby
April 2 (Reuters) – Dallas Federal Reserve President Lorie Logan on Thursday laid out paths and options for the U.S. central bank to reduce the size of its balance sheet, in remarks that noted the current system works well and offers benefits for overall financial stability.
“When it comes to the balance sheet, as with all of the Fed’s work, the focus needs to be on how we can best serve the public and support a strong economy and financial system,” Logan said in the text of a speech prepared for delivery at an event at the Dallas Fed.
“We should use our balance sheet efficiently and effectively,” Logan said, while adding that “balance sheet growth isn’t bad if it serves the public, but neither should we waste balance sheet space and let it be a distraction from our mission.”
Logan said the current system the Fed uses to manage financial liquidity, which seeks to provide an “ample” level of reserves, “is efficient and effective” and “pressing banks to economize on reserves would only increase risk in the system.”
There are, however, ways within the current system to help reduce the size of the Fed’s holdings, many of which center on the rules that govern how financial institutions manage their cash stockpiles, Logan said.
REGULATORY CHANGES COULD HELP SHRINK FED’S FOOTPRINT
The U.S. central bank has been rebuilding liquidity since late last year after spending several years drawing down bank reserves that were added to the financial system during the COVID-19 pandemic.
The Fed more than doubled the size of its holdings during the pandemic to a peak of around $9 trillion by 2022, after which it began allowing bonds it owned to mature and not be replaced. That policy allowed Fed holdings to contract and they now stand at around $6.6 trillion. Bank reserves are around $3 trillion, a level they’ve bounced around for some time.
The Fed’s ample reserves system, built over a number of years and formalized in 2019, is designed to make sure the financial system has enough liquidity to allow the central bank to fully control its interest rate target, while allowing for acceptable levels of money market interest rate volatility.
The system has delivered on interest rate control, but the ongoing large size of the balance sheet has generated controversy. It’s also put the Fed in an unusual period of loss-making. Kevin Warsh, who has been tapped to succeed Fed Chair Jerome Powell when his leadership term ends in May, has criticized the central bank’s balance sheet management and says he wants smaller holdings.
Research from in and outside the Fed in recent days has argued that the central bank could reduce the size of its holdings under the current system primarily through regulatory changes that would induce banks to hold lower levels of reserves, which in turn would allow the Fed to shrink its footprint further.
In her remarks and in an accompanying essay sketching out options, Logan agreed that regulatory changes could be effective, pointing to work now happening in the Fed that could make reserves management “more efficient,” especially in times of stress.
Logan also said broadening access to Fed liquidity facilities could reduce financial firms’ interest in keeping lots of cash on hand, noting that work on this effort is ongoing when it comes to discount window lending and other Fed liquidity operations.
“Shifting the demand curve inward through steps like these holds substantial promise for reducing reserves while maintaining the benefits of the ample reserves framework,” Logan said. She also noted that there are complex interactions between actions undertaken to reduce demand for reserves which could complicate estimating long-run benefits of the changes.
(Reporting by Michael S. Derby; Editing by Paul Simao)
