By Jonathan Spicer and Ann Saphir
NEW YORK/SAN FRANCISCO (Reuters) - Once the Federal Reserve lifts interest rates from near zero, likely this week, the focus will turn to the other legacy of the crisis-era policies: the Fed's swollen balance sheet.
The prevailing view is that the U.S. central bank's $4.5 trillion portfolio, vastly expanded by bond purchases aimed at stimulating the economy, will have to shrink once rates are on their way up, and the Fed will just need to decide how quickly.
Now, however, there is a new twist to the debate, with some policymakers and outside experts saying that there are reasons to keep the balance sheet big.
Arguments in favor of a leaner pre-crisis era Fed portfolio have been well laid out. A smaller balance sheet would mark a return to "normal" policy, minimize the Fed's impact on the allocation of credit across the economy, and help defuse political pressure from critics accusing the Fed of overextending its influence beyond its core monetary mandate.
As recently as September 2014, the Fed pledged to eventually "hold no more securities than necessary," in its "normalization" plan, a level widely interpreted as close to its pre-crisis $900 billion size.
Today as the long-anticipated rate lift-off draws close, the central bank appears to be warming to the idea of a sizeable balance sheet.
A "permanently higher balance sheet ... is something that we haven't studied that much but I think needs a lot more thought," John Williams, president of the San Francisco Fed, said last month.
A big Fed portfolio could help stabilize financial markets by inducing banks to keep greater amounts of money in reserve, advocates say.
It could also give the Fed a permanent policy tool with which to target sectors of the economy and certain parts of the bond market.
For example, the Fed could buy and sell certain assets to stimulate or cool the mortgage market or to affect longer-term borrowing costs, says Benjamin Friedman, former chairman of Harvard University's economics department.
BUBBLES AND RUNS
Experts addressing a conference hosted by the Fed last month, said the central bank Fed could use the assets as a new "macro prudential" tool to deal with financial market bubbles - by cooling particular sectors with targeted asset trades - and ward off investor runs by letting ample bank reserves act as a buffer.
And while the Fed is now replenishing its portfolio as bonds mature and plans to continue doing so for another year or so, policymakers have directed staff to examine alternatives and to consult outside experts, according to minutes of the Fed's July meeting.
For example, Fed researchers have been studying how many and what type of bonds should be stay on the Fed's books in a "post-normalization world" - an effort one source familiar with the work called a "once in a decade" research opportunity.
Ben Bernanke, who as Fed Chairman unleashed the bond-buying that pushed the balance sheet to its current size, also weighed into the debate downplaying any concerns about the Fed's outsized portfolio.
"The Fed could leave the balance sheet where it is and that wouldn't be a problem," he told New York Economics Club last month, noting its size is "internationally normal" in relation to the economy's output.
To be sure, some policymakers and economists still see compelling reasons to shrink the Fed's holdings. James Bullard, president of the St. Louis Fed, said last week it would be "prudent" to bring it to "more normal levels."
One result of the swollen portfolio is the $2.6 trillion in excess reserves that banks now park at the Fed, earning interest that will only rise as rates tick higher.
The idea that the Fed is paying extra billions to the very banks blamed for the crisis could re-ignite criticism from lawmakers already sour on the Fed's aggressive stimulus.
A big balance sheet poses "huge optics problems," says John Cochrane, a senior fellow at the Hoover Institution.
Still, there are obvious financial stability benefits to keeping the balance sheet large, he says. The debate, Cochrane adds, should center on whether to hold on to both long- and short-term bonds, and whether to dump mortgage bonds and retain only Treasuries.
One thing is clear: the Fed has not shut the door on keeping a bigger balance sheet for longer, or using it as a policy tool on top of its usual lever of setting short-term borrowing costs.
(This story has been refiled to fix the wording in the first paragraph.)
(Reporting by Jonathan Spicer and Ann Saphir; Editing by Tomasz Janowski)