Kansas City Federal Reserve Chair Esther George speaks to the National Association for Business Economics in Denver, Colorado, U.S., October 6, 2019. REUTERS/Ann Saphir

March 30 (Reuters) – The brief inversion in the U.S. bond yield curve on Tuesday is a warning sign for the Federal Reserve that may need to be heeded in upcoming debates over central bank balance sheet management said Kansas City Fed President Esther George. Wednesday.

George said she was less concerned about what the brief negative spread between 10-year and two-year Treasuries signaled of a possible recession, than about the implications for financial stability and the stress it might exercise on bank lending models.

While the Fed plans to raise short-term interest rates, she said, this could make a reversal even more likely unless the Fed also raises long-term rates by shrinking its balance sheet.” in a significative way”.

“The balance sheet will have to come down significantly,” she said, citing the “distorting effects” that the Fed’s nearly $9 trillion holdings are having on financial markets. She said those holdings may have lowered 10-year Treasury yields by up to 1.5 percentage points. “The interaction of higher policy rates with a large balance sheet will have to be considered,” George said. “Rising short-term rates as the balance sheet continues to depress longer-term yields will contribute to a flattening and reversal.”

The Fed is expected to announce its balance sheet reduction plans as early as its May meeting, with some details likely to be revealed in upcoming March meeting minutes.

As for short-term interest rates, George said they could be raised “regularly and deliberately” in the coming months as the Fed tries to control inflation which has exceeded its target of 2%.

As rates rise, George said, the Fed will need to assess how the economy is responding to tighter financial conditions, and also how global developments, including the pandemic and the war in Ukraine, are influencing both the supply of goods and economic growth and demand.

“Much of the economic fallout so far has been directed to further supply disruptions,” which would add to inflation, she said. But “both of these risks also have implications for demand… It will be difficult to assess the balance in real time. Acknowledging these risks is not an argument for delaying housing removal, but it does suggest a steady approach and deliberate for the political could provide space to monitor developments as they unfold.”

Reporting by Howard Schneider; Editing by Andrea Ricci

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