| SAN FRANCISCO/NEW YORK
SAN FRANCISCO/NEW YORK With the wind-down of the Federal Reserve's massive bond buying under way, policymakers are beginning to discuss the next stage - when to allow the U.S. central bank's swollen balance sheet to shrink.
If the Fed sticks to a plan laid out in June 2011, a decision to stop reinvesting bond proceeds would precede any increase in interest rates and mark the beginning of the Fed's first tightening cycle since 2004-2006.
But at least some officials are having second thoughts.
Discussions with several policymakers suggest some would rather make the delicate shift around the same time as the first rate increase, perhaps near the middle of next year.
And those who stick by the Fed's original plan say they must make sure markets understand that leaving the buyers club does not mean higher rates are necessarily right around the corner.
Either way, a decision to finally stop reinvesting proceeds from its Treasuries and mortgage-backed securities would mark the first step in an effort by the Fed to shrink its balance sheet from unprecedented levels.
Halting reinvestments would send a strong signal to the public that the recession-hit U.S. economy has effectively regained its footing and should prepare for higher rates. It also would modestly reduce downward pressure on long-term borrowing costs, unless markets mistook it as a signal of a more aggressive move to come.
San Francisco Federal Reserve Bank President John Williams told Reuters such a move would indicate rate hikes were coming in the "foreseeable future," but not that they were "imminent."
"What we have to be careful about and very deliberate about in communicating is that this action should not be misconstrued or misinterpreted as a signal of an imminent rate hike, or, if you will, tighter policy than people were otherwise expecting."
That, Williams said, was the hard lesson learned last May. At that time, stocks and bonds swooned after then Fed Chairman Ben Bernanke suggested the central bank would begin to reduce its bond-buying program in coming months.
"You want it to be part of that glide path, if you will, as part of our policy that we expect interest rates to remain low for a few more years," he said in the interview. "What worries me that whenever we do one thing, people read too much into it."
A QUESTION OF SEQUENCING
Financial markets have shown great sensitivity to any sign rates might move up sooner than had been expected.
Last month, the Fed said there would be a "considerable time" between the end of the asset purchases and the beginning of rate hikes. But when Fed Chair Janet Yellen said that could mean six months, markets took a dive.
The question of reinvestments, however, has so far attracted little attention.
"We could play that card at any time," St. Louis Fed President James Bullard told reporters last week at an investment conference in Hong Kong. "I think the markets have forgotten about that element of policy."
Most economists think the Fed will keep topping up its balance sheet for some time after it stops outright bond purchases. Announcing an end to that practice could help set the stage for a pending rate hike.
"That decision is a key ammunition, and it is unlikely the Fed will spoil two cartridges at the same time by ending the reinvestment while hiking (rates)," said Thomas Costerg, an economist at Standard Chartered Bank. "The Fed will likely shoot gradually one after the other."
A more cautious approach, however, would be to halt reinvestments at the same time that rates are raised from zero, where they have been since late 2008.
"When we finally get to the point when we need to increase the funds rate, probably most likely ... we would have still been reinvesting the proceeds," Chicago Fed President Charles Evans told reporters at the Hong Kong conference.
"Then we'll make a judgment as to when it will be appropriate to start letting that run off a little bit."
SHRINKING WELL INTO NEXT DECADE
In a research paper a year ago, top Fed economists assumed reinvestments would be halted six months after the end of the asset purchases and six months before the first rate hike. That, however, runs counter to Yellen's suggestion that a rate hike might come much sooner.
In 2011, the Fed outlined its so-called exit strategy in which halting reinvestments was the first step to shrinking its balance sheet, which now tops $4 trillion, down to a more normal size around $1 trillion.
New York Fed President William Dudley has called that strategy "stale" in part because the Fed has since abandoned a key pillar: the eventual sale its mortgage-backed securities.
The strategy may also need updating because the central bank will likely rely heavily on a new facility that will drain bank reserves through reverse repurchase agreements, a tool that was not available when the paper was published.
Yet officials are wary of formally updating the strategy, possibly for fear of chaining themselves to a specific plan as they navigate a difficult policy reversal.
Out of a handful of Fed policymakers asked in recent months whether it was time for an update, only Williams agreed.
In the interview on Wednesday, Williams said he does not, however, think the Fed needs to issue a formal statement spelling out an updated exit strategy, including whether to halt reinvestments before rate hikes, or after.
Both approaches "have pluses and minuses - I don't really have a view about whether one is better than the other," he said. "What's important to us is to make sure that whatever our plan is around those specific technical details, that we explain ... what are our broad plans and try to help people understand that and not to over-misinterpret things."
Since very few of the Fed's Treasury bonds expire before 2016, the initial effect on markets could be small. But the run-off will increase over the following few years and last for more than a decade to come, based on current holdings.
(Reporting by Jonathan Spicer and Ann Saphir; Additional reporting by Michael Flaherty in Hong Kong; Editing by Tim Ahmann and Chizu Nomiyama)