There is quite a bit of speculation on the reasons why the Fed is eyeing the shadow banking system, aka the Money Market Funds, as a target for the reverse repos when they see the need to drain liquidity from the system.
The following chart shows that as the Fed expanded the monetary base, the liqudity was not being accumulated across the financial system proportionately.
There was a quite obvious parabolic increase in excess reserves held at the Fed as one would expect from a balance sheet expansion, for which the Fed is now paying interest.
From the look of the institutional money funds, one might surmise that beginning with the first failures of major banks, there were heavy flows of liquidity into the institutional money market funds from a variety of sources, with less into the retail funds, and very little change in demand deposits at commercial banks. This would have been consistent with a flight to safety in 'cash.'
Why is the Fed eyeing the money market funds? Two reasons perhaps.
First and most simply because, as notorious criminal Willy Sutton once said, that is where the money is. And if it stays there, the Fed must find a way to affect it to drain liquidity while mitigating the effects of their actions on specific institutions and sectors of the financial system.
Secondly, there is a strong possibility that the Fed's initial attempts to drain will not only involve reverse repos, but also an increase in the interest rate which it pays on the excess reserves.
As you know, one of the reasons the Fed wished to pay this interest rate is as a means of putting a 'floor' under short term rates during a period of significant quantitative easing. If the Fed is paying .15 percent on reserves, for example, it is unlikely that short term rates will fall below .15 percent, without regard for the tranches of liquidity it may be adding to shore up the balance sheets of the banks.
Conventional open market operations tend to become sluggish, if not unmanageable, as one approaches zero rates. Therefore Benny 'got a brand new bag.'
Since the Money Market Funds do not place their excess reserves with the Fed, there is an obvious need to somehow tie them into the process, if one intends to manage it gracefully, not tilting the real economy in one direction or the other, as we are sure our Maestro Ben wishes to do.
It was a bit of an eye opener for us to see this comparison of the Funds with the Banks, and the overall expansion of the Base in the period of fiancial crisis.
Granted, wherever the Fed drains there will be at least a temporary 'crowding out' that needs to be managed carefully. Goldilocks and all that.
No doubt the Banks who own the Fed are keenly interesting in making sure that no additional advantage is being given to the Funds in their ability to attract capital, and invest in even short term paper which might prove advanageous in a recovery. The Vampire Squid and its Merry Band of Lame-os do not like competition.
It is also interesting to note the hints being dropped by various Fed heads for the need to draw the regulation of the Funds under their purview, away from the SEC.
And the SEC is contemplating tougher rules on required reserves for the retail and institutional funds, as well as stricter guidelines on what they may hold on their books.
Sometimes the simplest, most straightforward possiblities are the best. And until additional data may prove otherwise, it does not appear that the Fed wishes to 'dump toxic assets' on the Money Market Funds. Rather, it looks to be all about financial engineering, and a desire to attempt to manage the downstream effects more carefully.
Financial engineering is quite possibly a quagmire, and the Fed in fairly deep within it.
