Easing regulations could lead to smaller Fed balance sheet, Miran says

By Michael S. Derby

(Reuters) -Federal Reserve Governor Stephen Miran said on Wednesday that easing financial firms' regulatory burden could allow the U.S. central bank to shrink the size of its balance sheet again in the future.

"As we make more progress peeling back regulations, I expect the optimal level of reserves may drop below where it is now, at least relative to GDP or the size of the banking system," Miran said in the text of a speech to be delivered to an event hosted by the Bank Policy Institute and Small Business & Entrepreneurship Council in Washington.

If the regulatory footprint gets lighter,?"it is possible that in the future, it will be appropriate to resume shrinking the balance sheet; stopping run-off today does not necessarily mean stopping it forever," Miran said. Before shrinking Fed holdings further, "we first have to get the regulations right and ensure that bank balance sheets are flexible enough for an environment with a smaller Federal Reserve footprint."

Miran, who is on leave from his job as an economic adviser in the White House to fill a Fed governor term that expires early next year, said that even as he hopes the central bank can at some point in the future reduce its footprint in markets, he nevertheless was on board with the policy-setting Federal Open Market Committee's decision last month to stop the contraction of central bank holdings.

"Given emergent funding market signals, I supported ending the runoff of the Fed's balance sheet immediately at the FOMC's October meeting rather than waiting until December 1, though the difference between October 29 and December 1 is not enormous," Miran said.

The Fed lowered its benchmark interest rate by a quarter of a percentage point at the October 28-29 meeting, while also announcing plans to stop the drawdown of its balance sheet at the start of next month.

Over the last three years the Fed has been allowing the bonds it bought during the COVID-19 pandemic to mature and not be replaced, in a bid to remove the excessive amount of liquidity it added during the crisis. Having more than doubled its overall holdings to a peak of about $9 trillion in the summer of 2022, the Fed now has a balance sheet that stands at around $6.6 trillion.

FED'S NEW DEREGULATORY DRIVE

The central bank ended its quantitative tightening, or QT, program due to mounting pressure in money markets. The goal of QT was to leave the financial system with enough liquidity that the Fed could retain firm control over its interest rate target while allowing for normal money market volatility.

In the run-up to the Fed's last policy meeting, key short-term borrowing rates began drifting higher and market participants began availing themselves of the central bank's liquidity tools. Following the October meeting, Fed officials said QT had effectively met their objectives, while also noting that some time soon the central bank would need to buy Treasuries again in a technical move to manage overall market liquidity.

The Fed is engaged in a new deregulatory drive that could affect how banks need to manage liquidity levels, which in turn impacts how the central bank will need to manage overall reserve levels in the financial system.

The still-large size of Fed holdings, at least in dollar terms, has caused concern in some quarters, although that does not extend to current central bank officials.

In his remarks on Wednesday, Miran said smaller Fed holdings "would also enable us to reduce our interest payments on reserves," adding that "if we go far enough with removing regulations, we may be able to limit perceptions that the Fed is picking winners and losers through regulations, asset purchases, and credit allocation decisions."

(Reporting by Michael S. Derby; Editing by Paul Simao)