By David Milliken
LONDON (Reuters) - The Bank of England's balance sheet is likely to roughly halve to around 275-375 billion pounds ($341-465 billion) when the time comes to reverse quantitative easing, a senior official said on Wednesday.
It currently exceeds 600 billion pounds, having ballooned after the financial crisis as the BoE bought hundreds of billions of pounds of British government bonds to boost the economy.
Previously, the BoE said it expected its balance sheet to shrink when it ultimately reverses quantitative easing, but not to return to pre-crisis levels due to a long-term increase in commercial lenders' demand to hold reserves at the central bank.
On Wednesday Andrew Hauser, the BoE's executive director for markets, gave a specific estimate, and explained how the BoE intends to reduce any side-effects of gilt sales on banks' day-to-day cash management.
"The ... framework that we are proposing ...will allow the size of the balance sheet to be determined independently from the quantity and composition of quantitative easing and quantitative tightening," he said.
The structure of the BoE's balance sheet affects how changes in interest rates are passed on to borrowers, and the ease with which banks can send each other money, though the BoE does not think it drives the volume of bank lending in Britain.
Currently, as a side-effect of QE, financial institutions hold far higher reserves at the BoE than they would normally need to facilitate interbank payments and meet short-term liquidity needs.
Based on conversations with firms, Hauser said the financial system probably only needs to hold 150-250 billion pounds of reserves - roughly a third to half the current level.
Adding other liabilities such as banknotes in circulation, this would suggest the BoE's balance sheet should be 275-375 billion pounds - equivalent to 12%-18% of annual economic output - after quantitative easing has been reversed, he said.
He said there was no "mechanical link" between that figure and the quantity of gilts the BoE will need to sell, and that banks' desire to hold reserves would not put a cap on gilt sales.
Sales are likely to be some time away. The BoE has previously said it will not start to sell down its 435 billion pounds of gilt holdings until Bank Rate rises to around 1.5%.
The BoE plans to hold open market operations to lend reserves to banks at the prevailing Bank Rate, which it said would give it more flexibility over how it managed its balance sheet while it sold gilts back to the market.
However, market interest rates were likely to carry a slightly greater premium and be somewhat more volatile as banks adjusted to the new system, Hauser said.
"As a one-off shift, this is unlikely to be of great significance to the setting of monetary policy," he said.
(Reporting by David Milliken, editing by Michael Holden and John Stonestreet)