NEW YORK (Reuters) – Federal Reserve Governor Stephen Miran said on Thursday that reducing the financial system’s demand for high levels of liquidity could allow the central bank to substantially trim the size of its still large balance sheet and facilitate a more flexible monetary policy stance than it would otherwise.
“Reducing the size of the balance sheet is desirable” and those who say that cannot happen “simply lack imagination,” Miran said in the text of a speech he will deliver before the Economic Club of Miami.
Miran said that easing liquidity regulations, tightening banks’ stress testing, along with destigmatizing the use of the Fed’s liquidity facilities such as standing repo operations and the discount window, as well as having the Fed engage in more active interventions to manage market liquidity, could collectively allow the current $6.7 trillion balance sheet to become noticeably smaller over time.
The range of options to reduce the market’s desire to maintain substantial levels of reserves “could reflect between $1 and $2 trillion of balance sheet reduction,” Miran said. At the same time, he said, any measure to implement this path would likely take several years to achieve its goals, but doing so would bring benefits, he said.
Miran said the size of the Fed’s holdings now distorts markets and deprives the central bank of an avenue to provide stimulus when the next round of trouble hits.
“I would recommend a slow pace of reductions to ensure that the private sector can absorb all the securities removed from our own balance sheet, and that reductions in the amount of bonds held by the Federal Reserve should occur passively, rather than through active sales, Miran said.
Miran said a smaller balance sheet would also allow interest rates to be lower than they would otherwise be.
“All things being equal, reducing the balance sheet has contractionary effects on the economy,” the Federal Reserve governor said. “The contractionary economic effects of balance sheet reduction can be offset by a lower federal funds rate, as long as we are not at the effective lower bound.”
BALANCE SHEET MOVEMENTS
Miran’s roadmap for reducing the Fed’s balance sheet lands at a time when the Fed is going in the other direction and expanding its holdings, albeit for technical reasons.
The Federal Reserve purchased trillions of Treasuries and mortgage bonds during the COVID-19 pandemic to stabilize markets and provide economic stimulus. That more than doubled the Federal Reserve’s holdings to a peak of about $9 trillion by 2022.
That same year, the Federal Reserve allowed a set amount of its bonds to mature and not be replaced and carried out a process called quantitative tightening, or QT, until the end of last year. During a key part of the QT, the Federal Reserve also raised its interest rate target in an attempt to reduce high levels of inflation, although by 2024 the movement of the federal funds rate diverged from what the Fed was trying to do through the QT.