NEW YORK, March 26 (Reuters) - Federal Reserve Governor Stephen Miran on Thursday said reducing the financial system's demand for high levels of liquidity could allow the central bank to substantially cut the size of its still large balance sheet and facilitate an easier stance of monetary policy than would otherwise be the case.

"Shrinking the size of the balance sheet is desirable" and those who say it can't happen "simply lack imagination," Miran said in the text of a speech to be delivered before the Economic Club of Miami.

Miran said easing liquidity regulations, tweaking bank stress tests, together with destigmatizing the usage of Fed liquidity facilities like standing repo operations and the discount window, as well as the Fed engaging in more active interventions to manage market liquidity, could collectively allow the now $6.7 trillion balance sheet to be notably smaller over time.

The range of options for reducing the market's desire to hold substantial levels of reserves "could reflect $1 trillion to $2 trillion of balance sheet reduction," Miran said. At the same time, he said, any move to implement this path would likely take several years to achieve its goals, but doing so would bring benefits, he said.

Miran said the size of Fed holdings now distorts markets and deprives the central bank of a path to provide stimulus when the next round of trouble arrives.

"I would counsel a slow pace of reductions to ensure the private sector can absorb all the securities shed off our own balance sheet, and that reductions in the amount of bonds held by the Fed should happen passively, rather than via active sales, Miran said.

Miran said a smaller balance sheet would also allow for interest rates to be lower than they otherwise would be.

"All else equal, reducing the balance sheet has contractionary effects for the economy," the Fed governor said. "Contractionary economic effects of balance sheet reduction can be offset with a lower federal funds rate, so long as we are not at the effective lower bound."

BALANCE SHEET MOVES

Miran's roadmap for shrinking the Fed's balance sheet lands as the Fed is going the other direction and expanding its holdings, albeit for technical reasons.

The Fed bought trillions of Treasury and mortgage bonds during the COVID-19 pandemic to stabilize markets and provide economic stimulus. That more than doubled Fed holdings to a peak of around $9 trillion by 2022.

That same year, the Fed allowed a set amount of its bonds to mature and not be replaced and ran a process called quantitative tightening, or QT, until late last year. For a key part of QT, the Fed also raised its interest rate target as it sought to lower high levels of inflation, although by 2024 the movement of the federal funds rate diverged from what the Fed was trying to do via QT.

By late last year, the pace of runoff reached a point where it was beginning to destabilize money market rates, which in turn could have created challenges for the Fed to manage the interest rate target it uses to pursue its monetary policy goals. That caused the Fed to end QT and to start buying substantial amounts of Treasury bills to rebuild market liquidity and calm money market conditions.

Fed officials have been broadly supportive of their current system to manage interest rates and some have said there are limited benefits to removing liquidity from markets for its own sake.

Kevin Warsh, who has been named to succeed current Fed Chair Jerome Powell when his leadership term ends in May, has expressed interest in shrinking the Fed's balance sheet, and Miran's work may help provide a road map for that effort.

"I am not advocating any specific step," Miran noted, "I'm simply listing options we were able to identify, so that if and when the time comes, the Fed will have some tangible actions we can take to move in this direction. Each option will require its own cost-benefit analysis."