Fed's Barr says wrong to lower liquidity rules to shrink Fed holdings

* Fed's Barr says misguided to ease bank liquidity rules to lower Fed holdings

* Barr says efforts to cut Fed balance sheet via rule changes could increase risk

* Barr says current Fed policy system has worked well

By Michael S. Derby

NEW YORK, May 14 (Reuters) - Federal Reserve Governor Michael Barr said Thursday that lowering liquidity rules to get the central bank's balance sheet smaller is a bad idea and could undermine the safety of the financial system.

"There has been a lot of discussion of late about reducing the size of the balance sheet of the Federal Reserve to reduce our 'footprint' in the financial system," Barr said in the text of a speech to be delivered in New York before a gathering held by the Money Marketeers of New York University.

"I think shrinking the balance sheet is the wrong objective, and many of the proposals to meet this objective would undermine bank resilience, impede money market functioning, and, ultimately, threaten financial stability," Barr said, adding: "Some would actually increase the Fed's footprint in financial markets."

Barr said that allowing banks to hold less liquidity as a tool to shrink Fed holdings would likely increase the risk of these institutions turning to Fed liquidity facilities in times of trouble.

"If anything, the bank stresses of 2023 suggest that liquidity requirements should go up and not down," given what happened to banks during that period.

What's more, he said, "the size of the Fed's balance sheet is the wrong measure of the Fed's footprint in financial markets" and in a system where creating reserves is "costless" for the Fed, the real focus should be on how effective the Fed is implementing monetary policy.

"The current regime has achieved" monetary policy objectives "for many years" and "effective policy implementation also supports smooth market functioning," Barr said. (Reporting by Michael S. Derby; Editing by Edmund Klamann)