Fed thinking about growing balance sheet again: K.C. Fed paper

NEW YORK (Reuters) - The U.S. Federal Reserve is considering when to stop reducing bank reserves and start building up its balance sheet again, according to a paper from the Kansas City Fed released on Wednesday.

FILE PHOTO: Flags fly over the Federal Reserve Headquarters on a windy day in Washington, U.S., May 26, 2017. REUTERS/Kevin Lamarque/File Photo/File Photo/File Photo

Analysts and traders worry that a shrinking Fed balance sheet is making it expensive for banks to finance loans and trading positions, restricting their lending to companies and consumers.

U.S. monetary policymakers bulked up their books with bank reserves in order to buy trillions of bonds and stimulate the economy further once rates neared zero after the 2008-2009 global financial crisis. To restore policy to normal, the Fed began shrinking its balance sheet in late 2017 by not replacing as many bonds when they mature.

But investors have been critical, and U.S. President Donald Trump even urged the Fed in a tweet in December to “Stop with the 50 B’s.” Balance sheet reductions are capped at $50 billion a month.

Fed Chairman Jerome Powell said last month that the bond shrinkage would stop this year, citing banks’ growing demand to keep cash with the Fed and technical factors regarding how policymakers currently set rates.

The Fed may need to hold as much as $1.5 trillion in bank reserves on its balance sheet to properly implement monetary policy, according to the research by Kansas City Fed Senior Economist A. Lee Smith released on Wednesday.

That would be a relatively small decline from less than $1.7 trillion now, implying as little as a few more months of reductions. Fed officials have mostly been citing lower estimates of what level of reserves would be needed, some not produced by the bank’s own researchers.

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GRAPHIC-Bank reserves held at the Fed:

Asked about the estimate by Reuters on Wednesday, New York Fed President John Williams said the Kansas City figure is at the high end of analysts’ estimates.

“There’s a range of estimates out there about what’s the level of reserves consistent with there being abundant reserves in the system so that interest rates really are being controlled not by scarcity of reserves but by the interest rates that we set,” said Williams, who had not read the paper.

“There is no clear answer to this. ... Personally my view is we’re nowhere near the point” where reserves are scarce, he added.

The New York Fed is charged with implementing the balance sheet policy.

Smith’s estimate is based on an assumption that the Fed will continue to operate, as now, with a near-zero gap between two bank borrowing rates, the federal funds rate and the interest rate the Fed pays on reserves. Were that spread to expand, the reserves estimate would fall to $1.1 trillion.

The “effective” or average fed funds rate has been running at 2.40 percent since mid-December, which is at parity with the interest rate on reserves.

Smith wrote last month that the shrinkage of the U.S. balance sheet has played a significant role in exerting upward pressure on borrowing costs.

GRAPHIC-U.S. federal funds activity:

Reporting by Trevor Hunnicutt and Richard Leong; Editing by Chizu Nomiyama and Richard Chang