By Steven K. Beckner

PHILADELPHIA (MNI) - Philadelphia Federal Reserve Bank President Charles Plosser said Wednesday that the Fed will need to reduce the size of its balance sheet on a permanent basis as and when it raises interest rates to tighten monetary policy, and he said his preferred method of doing that is outright asset sales.

Other tools, such as reverse repurchase agreements and term deposit facilities, do not shrink the balance sheet and that will cause lingering problems for the Fed as it seeks to tighten credit, Plosser said.

Plosser, talking to reporters following a speech to the World Affairs Council of Philadelphia, was also skeptical about the Fed's ability to rely on paying interest on reserves as a means of tightening monetary policy. He said the sheer cost of paying banks interest on their massive reserves is another reason why the Fed needs to shrink those reserves.

Plosser, who is not voting on the Fed's policymaking Federal Open Market Committee this year, said the actual timing of monetary tightening will depend on how economic conditions evolve. He said he could imagine the Fed tightening either before or after the fourth quarter, which is the current market consensus for the start of rate hikes.

Plosser said the timing of asset sales would also depend on economic and financial conditions. To avoid disrupting mortgage and other markets, he said the Fed will likely pre-announce some schedule of sales, just as it originally announced a schedule of purchases of Treasury, agency and agency guaranteed mortgage backed securities.

In his prepared remarks, Plosser said he would like to see the Fed start selling assets to shrink its balance sheet back toward pre-crisis levels "sooner rather than later."

MNI asked him whether he thinks the Fed will need to shrink bank reserves before it starts raising rates and whether he thinks the Fed should use outright asset sales to do that, as opposed to using such tools as reverse repos and the proposed term deposit facility. He indicated a strong preference for asset sales, but was more equivocal about whether they need to be done before or simultaneously with rate hikes

"I think the other tools don't shrink the balance sheet," Plosser replied. " None of the other tools shrink the balance sheet."

"I think that ultimately we have to shrink the balance sheet," he continued. "So my view is that we'll have to begin shrinking the balance sheet."

"Now when we do that in terms of timing of interest rate increases versus ... in my view that's still an open question, okay," Plosser went on. "I'm not opposed to and might even favor shrinking balance sheet before we raised rates as a way of beginning to shrink the balance sheet, because ultimately the balance sheet has got to get down."

"If we're going to control the funds rate at some point we can't control it with a $2 trillion balance sheet," he said. "So we've got to begin getting balance sheet down."

"All the other tools, whether it be the reverse repos or the time deposits, they don't shrink balance sheet, they just delay it," Plosser said further, "and they only delay it if they prove effective."

"And we don't know how effective they're going to be," Plosser continued. "We don't know at what pace, if you just rely on interest on reserves and wanted to raise interest on reserves we have no idea how fast we're going to have to raise that if we want to keep the amount of reserves in the system that we want in order to hit the target. So that would be a lot easier to do if the balance sheet were smaller."

Plosser also raised concern about the cost of paying ever higher rates of interest on reserves as the Fed tightens in response to another MNI question.

"That's another reason to shrink the balance sheet," he said, adding, "It's not going to be the most popular thing" to pay large amounts of interest to banks.

"It would be better to have a smaller balance sheet so you didn't have to pay all that interest on reserves to a whole bunch of reserves that's sitting in the banking system," he said. "The costs are not great unless the balance sheet is a reasonable size, which is another reason you want to get back to a smaller balance sheet."

As for whether interest on excess reserves should be the Fed's permanent monetary target or just a temporary one, Plosser said, "ultimately ... we will still have to decide and think about what our operating regime is going to be once we get back to some sort of normal period-- whether our policy rate will be an administered rate like interest on reserves or whether it's going to be a market rate of some type like federal funds rate."

Plosser said he "would prefer that we target a market rate as opposed to an administered rate, which is another reason why you're going to need to get reserves down if you're going to target something other than the floor of interest on reserves. So all those kinds of things kind of play together but it may take awhile to get there given the size of the balanced sheet."

Regarding the timing of Fed rate hikes, Plosser said "It's all going to depend on economic conditions ... and everything is data dependent. It's going to be conditional on how the economy evolves."

"I could imagine a scenario where we'd want to raise them before (the fourth quarter) and I can imagine a scenario in which we wouldn't raise them until after that ... . It's going to depend on how economy unfolds, and I would rather have our (FOMC policy) language talk more about economic conditions affecting when we change rather than making some precommitment over some horizon that has no bearing in interpreting that."

(1 of 2)

** Market News International **