George Says Fed Should Allow Asset Runoff Prior to Rate Rise

Federal Reserve Bank of Kansas City President Esther George said the Fed should allow its balance sheet to shrink before raising the main interest rate, differing from an approach backed by New York Fed President William C. Dudley.

“Allowing the balance sheet to decline due to ‘passive runoff,’ which stops reinvesting the maturing securities, prior to the first rate hike is appropriate,” George said today in a speech in Breckenridge, Colorado. She doesn’t vote on monetary policy this year.

The Federal Open Market Committee will need to decide in the “relatively near future” on how to withdraw accommodation that has pumped up the Fed’s balance sheet to $4.32 trillion, George said.

Her preference for allowing “passive runoff” in the balance sheet aligns with the FOMC’s exit plan formulated in 2011, she said. Dudley, who holds a permanent FOMC vote as the panel’s vice chairman, said on May 20 such an approach could imply the Fed will raise the benchmark rate earlier than it intends.

Ending reinvestment of maturing securities prior to an increase in the benchmark lending rate “may not be the best strategy,” Dudley said.

“First, such a decision might complicate our communications regarding the process of normalization,” Dudley said in a speech before the New York Association for Business Economics in New York.

‘Initial Step’

“Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the committee’s intention,” Dudley said. He said the Fed has tools to raise the benchmark lending rate even with a large balance sheet.

George voiced an opposing view, calling on the Fed not to reinvest the proceeds from maturing securities.

“As the outlook improves, this modest step would begin the normalization process and is in line with the 2011 principles,” George said to business and community leaders. “Unless there is a major change in the outlook I see abiding by principles that the FOMC reaffirmed last year as important. Central banks should make efforts to follow through on their plans, otherwise they risk losing credibility.”

George has warned that the Fed’s policy of bond purchases and holding the main interest rate close to zero risk creating imbalances in the economy and financial markets and pushing up long-term inflation expectations. She dissented at FOMC meetings seven times last year, voicing concern that rising accommodation would spur excessive risk-taking.

‘Somewhat Sooner’

“It will likely be appropriate to raise the federal funds rate somewhat sooner and at a faster pace” than the FOMC now projects, 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, posing risks to achieving sustainable growth over the longer run,” she said.

The median projection by FOMC participants in March showed officials expect the main interest rate to rise to 1 percent at the end of 2015 and to 2.25 percent a year later.

Reducing stimulus may be turbulent, George said in response to an audience question.

“I tell people we should not expect it will be smooth,” she said. “There will be some learning in the process.”

The Standard & Poor’s 500 Index fell 0.1 percent to 1,923.61 at 3:18 p.m. in New York, while the yield on the 10-year Treasury note increased 0.06 percentage point to 2.59 percent.

George, who became chief of the Kansas City Fed in 2011, was the Fed district bank’s No. 2 official under Thomas Hoenig, now vice chairman of the Federal Deposit Insurance Corp. She joined the Kansas City Fed in 1982 and spent much of her career in bank supervision.

The Kansas City district represents Colorado, Kansas, Nebraska, Oklahoma, Wyoming, northern New Mexico and western Missouri.

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