Federal Reserve Bank of Kansas City President Esther George said the Fed should allow its balance sheet to shrink before raising the main interest rate, differing from an approach backed by New York Fed President William C. Dudley.

“Allowing the balance sheet to decline due to ‘passive runoff,’ which stops reinvesting the maturing securities, prior to the first rate hike is appropriate,” George said today in the text of remarks for a speech in Breckenridge, Colorado. She doesn’t vote on monetary policy this year.

The Federal Open Market Committee will need to decide in the “relatively near future” on how to withdraw accommodation that has pumped up the Fed’s balance sheet to $4.32 trillion, George said.

Her preference for allowing “passive runoff” in the balance sheet aligns with the FOMC’s exit plan formulated in 2011, she said. Dudley, who holds a permanent FOMC vote as the panel’s vice chairman, said on May 20 such an approach could imply the Fed will raise the benchmark rate earlier than it intends.

Ending reinvestment of maturing securities prior to an increase in the benchmark lending rate “may not be the best strategy,” Dudley said.

“First, such a decision might complicate our communications regarding the process of normalization,” Dudley said in a speech before the New York Association for Business Economics in New York.

‘Initial Step’

“Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the committee’s intention,” Dudley said. He said the Fed has tools to raise the benchmark lending rate even with a large balance sheet.

George voiced a differing view in calling for “passive runoff” of maturing securities.

“As the outlook improves, this modest step would begin the normalization process and is in line with the 2011 principles,” George said to business and community leaders. “Unless there is a major change in the outlook I see abiding by principles that the FOMC reaffirmed last year as important. Central banks should make efforts to follow through on their plans, otherwise they risk losing credibility.”