UPDATE 3-Fed's Sack-Asset sales likely passive, gradual

Mon Mar 8, 2010 6:39pm EST

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(Adds details from Q&A)

By Mark Felsenthal and Emily Kaiser

ARLINGTON, Va., March 8 (Reuters) - The U.S. Federal Reserve will likely shrink its vast holdings of mortgage-related and other longer-term securities passively and gradually, a senior Fed official said on Monday.

"A decision to shrink the balance sheet more aggressively could be disruptive to market functioning," Brian Sack, executive vice president at the Federal Reserve Bank of New York, told the National Association for Business Economics.

The assets will roll off fairly quickly with time, he said, adding that an aggressive approach to diminishing the Fed's holdings would risk a spike in longer-term interest rates.

The Fed is close to completing its scheduled purchases of around $1.7 trillion of mortgage-backed securities, agency debt and longer-term Treasuries it launched to boost the economy after cutting rates to near zero.

The Fed has said high unemployment and low inflation make it necessary to hold rates exceptionally low for an extended period.

But with evidence the economy has begun to recover from the worst financial crisis in generations, Fed officials have begun to explain how the U.S. central bank plans to unwind its extraordinary support for the economy.

Some Fed officials argue that the Fed should actively sell assets to help steer its tightening of financial conditions.

Sack said that while reversing the Fed's low rates and massive infusions of cash into the economy will involve steps it has never taken before, he is confident the central bank has minimized risks.

"We have worked hard to ensure we have all the tools needed to exit," he said. "If we communicate effectively, the markets should be clearly informed and well-prepared ahead of any exit."

Sack said assets would begin to shrink on their own. For example, the Fed estimates that more than $200 billion of mortgage-related debt it holds will mature or be prepaid by the end of 2011.

In addition, about $140 billion of Treasury securities mature between now and the end of 2011, he said.

As the Fed proceeds, it will lay out a path for interest rates as well as asset holdings, Sack said.

However, what the Fed says about the likely direction of its policy after its meetings is likely to be a more important guide to markets about the path of short-term interest rates than any decisions about draining reserves from the system, he added.

"It will be difficult for market participants to make precise inferences about the timing of increases in the target interest rate from the patterns of reserve draining alone," Sack said.

Discussing the future of Fed policy, Sack said the financial system may function better if banks' reserves are higher than they were before the financial crisis struck.

The Fed's monetary policy-setting committee had not yet decided whether to shrink reserves in the system to pre-crisis levels.

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