January 9, 2020 / 7:51 PM / in a month

Fed's Kaplan says rates 'appropriate,' flags balance sheet concern

DALLAS (Reuters) - The Federal Reserve has interest rates just about where they need to be to keep the U.S. economy growing, push down on unemployment and coax inflation back up to 2%, Dallas Federal Reserve Bank President Robert Kaplan said on Thursday.

Dallas Federal Reserve Bank President Robert Kaplan speaks during an interview in his office at the bank's headquarters in Dallas, Texas, U.S. January 9, 2020. REUTERS/ Ann Saphir

But the central bank’s massive balance sheet, at $4 trillion and growing? That’s a potential problem for Kaplan, a former Goldman Sachs banker whose expertise in markets may give him an influential voice in deliberations at the Fed over what, if anything, to do about it.

To Kaplan, figuring out how to temper growth in the Fed’s securities holdings will be a major focus for him and his staff in the new year.

His goal, he told Reuters, is to keep an expanding portfolio from fueling excesses in a financial system that — amid historically low interest rates, optimism on trade and other factors — is already showing some signs of elevated asset prices.

“I’m going to be wanting to actively explore options that would allow us to restrain from here growth in the Fed balance sheet,” Kaplan told Reuters in an interview at his bank’s Dallas headquarters. “I do think the growth in the balance sheet is having some impact on the financial markets and on the valuation of risk assets...I want to be cognizant of not adding more fuel that could help create further excesses and imbalances.”

Possible options, he said, include a “hard look” at the differences between how regulators treat banks’ holdings of Treasuries and reserves, and establishing a so-called standing repo facility that would allow banks to tap liquidity when needed.

Last fall an unexpected spike in short-term funding costs put the central bank on notice that its balance sheet might have gotten too small to accommodate banks’ need for liquidity. It had previously been systematically trimming its balance sheet as part of its pursuit of a more normal footprint in financial markets, following its large bond purchases after the crisis.

But the spike in short-term rates forced it to do an about face. It began injecting billions of dollars into the so-called repo market that banks tap for cash lending, and has been buying $60 billion a month in U.S. Treasury bills to expand its balance sheet to make sure there are ample reserves in its system to control its key target for lending rates.

Setting up a standing repo facility, Kaplan said, “might allow us to be more efficient with the overall size of our balance sheet, and it might also change (banks’) thinking about their need to hold reserves.” Such a facility would allow banks to easily trade their Treasuries for cash.

Kaplan declined to say how big he thinks the Fed’s balance sheet should be. And, he said, the central bank has a lot to debate on how exactly to structure a standing repo facility, including counterparties, where rates should be set, and what eligible collateral should be.

RATES AND INFLATION

After three rate cuts last year, the Fed’s current target range of 1.5% to 1.75% for short-term borrowing costs is “a roughly appropriate setting,” Kaplan said in the interview.

U.S. GDP, he said, looks to grow about 2% to 2.25% this year, “and if anything my growth outlook has firmed a bit in the last several weeks.”

That solid pace of growth - faster than his 1.75% to 2% estimate of the economy’s long-run sustainable pace — is driven largely by a strong consumer. Global growth and U.S. manufacturing he projected would remain sluggish but stable, and U.S. business investment should firm.

The Fed has indicated it will leave rates where they are unless there is a “material” change in the outlook, a view that Kaplan said he backed.

“If I saw growth running above potential... I’d be willing also to tolerate inflation running above 2% for some period of time, but I’m going to take into account other factors, including financial stability and the building of excesses and imbalances, and I will weigh all those factors in determining whether I think there should be an adjustment to monetary policy.”

(This story has been refiled to add dropped word in 8th paragraph)

Reporting by Ann Saphir; Editing by Chizu Nomiyama

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