June 3, 2014 / 6:31 PM / 4 years ago

Fed's George urges halt to bond reinvestment before rate hike

WASHINGTON (Reuters) - The Federal Reserve should let its balance sheet begin shrinking before raising interest rates, Kansas City Federal Reserve President Esther George said on Tuesday in remarks that highlight divisions over how to wind down years of crisis response.

Kansas City Federal Reserve Bank President Esther George is pictured in the bank's boardroom in this handout photo courtesy of the Kansas City Federal Reserve. REUTERS/Kansas City Federal Reserve/Handout

The Fed is on pace to end monthly asset purchases by October or December. In a speech prepared for delivery in Colorado, George said that once that happens, and before the Fed begins raising interest rates, the central bank should also stop reinvesting the proceeds as its $4 trillion in holdings of U.S. Treasury and other securities mature.

That would shrink the Fed’s balance sheet through “passive run-off,” and be part of a gradual return to a more normal Fed role in the economy.

It is also counter to the position spelled out in recent days by Fed members including New York Fed President William Dudley, who said bond proceeds should be reinvested until the Fed has begun raising interest rates in order to avoid sending a premature signal that the central bank feels the economy has healed.

George, among the bank’s more hawkish members, said that as economic conditions improve, the Fed should stick with clear plans to withdraw from the extraordinary set of policies it enacted in response to the crisis - including letting its balance sheet begin to shrink sooner rather than later.

Despite some lingering doubts about economic growth, she said that employment and inflation may reach their target levels faster than some of her colleagues anticipate, and require more aggressive interest rate increases.

“It will likely be appropriate to raise the federal funds rate somewhat sooner and at a faster pace,” George said. “My concern is that keeping rates very low into late 2016 will

continue to incentivize financial markets and investors to reach for yield in an economy operating at full capacity.”

The Fed has said it expects to keep rates low “for a considerable time,” and investors currently project rate hikes won’t begin until next summer and will proceed slowly.

She said she thinks unemployment will have dropped appreciably by the end of next year while inflation is already picking up in some areas. While there my be doubts about the pace of growth in the United States and globally, she said she expects conditions to improve as U.S. fiscal “headwinds dissipate.

“It is hard to see such persistent headwinds still weighing on the economy two years from now,” George said.

The debate over the pace, timing and method of the Fed’s exit from an era of unconventional monetary policy is intensifying as the date for key decisions approaches. While an interest rate increase is still perhaps a year away, the central bank is experimenting with ways to siphon $2.5 trillion in reserves from the banking system, and debating what to do with the massive amounts of bonds it bought to stimulate the economy.

Reporting By Howard Schneider and Dan Flahterty, Editing by Andrea Ricci

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