Fed’s George Says Balance-Sheet Cuts May Allow for a Flatter Rate Path

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Federal Reserve Bank of Kansas City President Esther George said the central bank could take less aggressive actions in raising interest rates by shrinking the balance sheet more forcefully, which she said could help to avoid dangerous financial imbalances.

“More aggressive action on the balance sheet could allow for a shallower path for the policy rate,” George said in prepared remarks to the Economic Club of Indiana on Monday. “Alternatively, combining a relatively steep path of rate increases with relatively modest reductions in the balance sheet could flatten the yield curve and distort incentives for private sector intermediation, especially for community banks, or risk greater economic and financial fragility by prompting reach-for-yield behavior from long-duration investors.”

George, who's been among the more hawkish group of Fed officials, didn't specify when or how much the Fed should raise interest rates or when it should start balance-sheet reductions, other than saying they should start earlier than the previous cycle, when they came almost two years after rate liftoff. Chair Jerome Powell said last week that officials were ready to raise rates in March to curb the strongest inflation in four decades, and the policy committee released some general principles on its balance-sheet normalization.

George said the Fed's balance sheet, now $8.86 trillion, should be reduced as much as possible to ensure it doesn't distort markets or mislead the public.

“The potential costs associated with an excessively large balance sheet should not be ignored,” she said. “A large balance sheet has the potential to intertwine fiscal and monetary policy in the public's eyes and could unintentionally pose risks to the Fed's independence and authority.”

The Kansas City Fed president expressed worry about holding long-duration securities in particular.

“By holding long duration assets, the Fed's balance sheet is depressing the price of duration, by lowering longer-term yields by as much as 1.5 percentage points according to some rules-of-thumb, incentivizing reach-for-yield behavior and increasing fragility within the financial system,” she said.

George repeated the case for normalizing policy with inflation near a 40-year high and a tight labor market, and the unemployment rate falling below 4%.