By Jonnelle Marte
(Reuters) -The Federal Reserve can move sooner to start reducing its bond holdings than in the past and aggressive action to shrink the U.S. central bank's portfolio could allow it to take a shallower path on interest rate increases, Kansas City Fed President Esther George said on Monday.
The Fed signaled last week that it is likely to start raising interest rates when it meets in March, and officials are expected to begin offloading more than $8 trillion in bond holdings later this year. George said both actions, which the Fed is taking to remove the extraordinary support provided during the pandemic, are connected.
"What we do on the balance sheet is likely to affect the path of policy rates and vice versa," George said during an event organized by the Economic Club of Indiana. "For example, if we took more aggressive action on lowering, pulling down that balance sheet, it might allow for fewer interest rate increases."
George said a different approach in which the central bank pairs a "steep path" for rate increases with more modest reductions to the balance sheet could lead to more financial risks.
She said such a scenario where the Fed is raising short-term interest rates while maintaining a large balance sheet "could flatten the yield curve." That could, in turn, lead to "reach-for-yield behavior from long-duration investors."
"All in all, it could be appropriate to move earlier on the balance sheet relative to the last tightening cycle," George said.