The Fed as Shadow Bank

What would you call an institution that holds a portfolio of mortgage-backed securities and government bonds, funded mostly by overnight borrowing at an annual interest rate of 0.25 percent?

If Goldman Sachs or Citadel (a hedge fund) did that, we would call it “shadow banking.” That is, the institution is engaging in maturity transformation without being regulated as a bank.

And that is the Fed as it operates today. It pays 0.25 percent interest on “reserves,” which is just a way of saying that the Fed is borrowing at 0.25 percent to fund its portfolio.

It may be worth spending some time thinking about the Fed as just another shadow bank. When other shadow banks do what the Fed does, we call it portfolio management or carry trading or riding the yield curve. We don’t use mumbo-jumbo like “monetary policy” or “inflation targeting” or “quantitative easing.”

The Fed’s role as a shadow bank was less obvious back in the days of textbook central banking, with the Fed’s liabilities consisting of non-interest-bearing reserves and currency, and its assets consisting of short-term T-bills. (Actually, the textbooks had it wrong. The assets were repo loans. The Fed has always been a big player in the Gary Gorton shadow-banking poster child known as the repo market.) Still, I think that if we had always thought about the Fed in terms of shadow banking we would have been on the right track.

Some people call the classic Fed liabilities “money” or “high-powered money.” But I do not find that so exciting. In my view, the market decides what to use as money.

I tend to think that shadow banking affects the economy. As with other forms of banking, when there is more of it, credit conditions are looser, and this makes it easier for businesses to keep experiments going. This can be a good thing–if enough experiments turn out well. It can be a bad thing–if the experiments include too many ideas that are not really sustainable.

However, banking and shadow banking that is centered around portfolios of government securities does nothing to help credit conditions for businesses. It just facilitates crowding out.

So what could be wrong with holding the view that the Fed has never been and never will be something other than just another shadow bank? Most economists would argue that the Fed did important things in the 1970s and 1980s. In the 1970s, it was too loose and we got inflation. In the early 1980s it tightened and inflation went away.

I would say that we could just as easily blame the rest of the shadow banks. Who was it that kept long-term interest rates below inflation in the 1970s? Who was it that made long-term rates shoot up in the early 1980s? I think that one can defend the notion that it was the rest of the shadow banks that did that, and the Fed just kind of followed along.

4 thoughts on “The Fed as Shadow Bank

  1. It’s not so clear to me what additional insight we gain by thinking of the Fed as “just another shadow bank”. It’s highly misleading to think of interest on reserves as the interest rate that the Fed pays to borrow. That implies that the Fed must pay a particular interest rate to borrow a particular amount and that is not correct. The Fed can pay any interest rate it wants on reserves and independently chose the quantity of its liabilities. Furthermore, fed liabilities are used to clear most (all?) payments. Those seem like important differences between the Fed and other shadow banks.

    I think it’s well understood that M4 (for example) depends a great deal on the behavior of the shadow banking system. And M4 is probably jointly determined with nominal and real output. But it would be a mistake to then conclude that the Fed can do nothing to affect M4.

    Consider the following thought experiment. What would happen to M4 if the Fed announced it would pay interest on reserves of 10% for the next year? Can there be any doubt about the short run impact to M4 and the rest of the economy in this case? Everyone would try to sell everything at once to get their hands on fed liabilities. On the other hand, if some other player in the repo market accidentally offered an interest rate of 10% it would probably just result in a transfer of wealth from one institution to another.

  2. The bad thing is too few ideas, the major ones that are unsustainable. It is true there risk assets and risk free assets but crowding out couldn’t exist if crowding in couldn’t as well. More government debt under those circumstances reduces risk. There are alpha banks and beta banks, but while alpha banks can acquiesce to beta banks, beta banks can’t order alpha banks around.

  3. “Some people call the classic Fed liabilities ‘money’ or ‘high-powered money.’ But I do not find that so exciting. In my view, the market decides what to use as money.”

    What is your response to the view that the Fed’s reserves/currency is unique because it is the medium of account? Wages are not sticky in terms of the number of corporate bonds, or even short-term T-bills, that one is paid per hour; they are sticky in terms of dollars (Fed notes). When the Fed issues more notes, the value of those notes falls when the prices of everything else rise. When shadow banks issue more notes, the values of those notes fall when the prices of those notes fall. That would seem to be a significant difference if price/wage stickiness is important.

  4. @Kling, you are much too generous to call the Fed “shadow banking”, and that they operate some sort of enconomic enterprise- with a balance sheet of assets and liabilities. Instead the Fed is simply a government agency with a mandate to make transfer payments between different cohorts and factions- namely from savers to other govt agencies, “non-shadow banks”, and education consumers. Did you know that student loans are the larget asset on the Fed’s balance sheet? Yellen/Bernanke consider student loans “asset-backed securities”. haha. Rather than a shadow bank, maybe call the Fed the RobinHood Student Loan Bank. http://www.advisorperspectives.com/dshort/commentaries/Federal-Government-Assets-and-Student-Loans.php

    The mumbo jumbo of QE, forward guidance, price stabiliity, taylor curve, blahblahblah… are all such sleight of word to to artifically push down the price of money and credit. It gives banking a bad name.

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