The June FOMC minutes were released on Tuesday. One interesting development we learned from it is that some FOMC members are becoming concerned that the Fed may be slowly taking on more and more financial intermediation activities that traditionally have been provided by banks. In the limit, this would amount to a nationalization of banking. The Fed would become the only bank and your local bank, if it were still around, would be its branch office. All money would be Fed liabilities and there would no longer be a distinction between inside and outside money. In other words, the Fed would directly control the money supply.1 Money supply targeting might actually become vogue again!
We are a long way from that point, but some FOMC members are concerned we are on that path to it. This concern centers around the Fed’s new overnight reverse repurchase agreement program (ON RRP). It provides a means for the Fed to temporarily return some its treasury holdings to a safe asset-scarce market and to influence short-term interest rates. It also provides a super safe alternative to institutional investors who normally park their funds in the money market. And that is where it could be problematic. Here is the FOMC:
In addition, a number of participants noted that a relatively large ON RRP facility had the potential to expand the Federal Reserve’s role in financial intermediation and reshape the financial industry in ways that were difficult to anticipate.
Writing in the Financial Times, Tracy Alloway expands on this problem:
The Federal Reserve Bank of New York has emerged as the single largest player in an important segment of the short-term lending market that was at the epicentre of the financial crisis.The Fed’s decision to quadruple its trading with government money market funds in the repurchase or “repo market” is a sign that the central bank is now engaging more directly with the shadow banking system at the expense of large Wall Street banks… Armed with a balance sheet of $4.3tn of bonds purchased during quantitative easing, the Fed is using what it calls its reverse repo programme, or RRP, to trade with money funds at a time when tough new regulatory standards have made such borrowing less attractive for the banks. Rather than lending to the banks, money market funds have sharply boosted their dealings with the US central bank.
Bill Dudley, New York Fed president, warned last month that if use of the repo facility were to grow too quickly it might “result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility. This could encourage further enlargement of the shadow banking system.” Without a cap on use of repo with the Fed, investors who ordinarily lend to banks could instead flock to the central bank in times of market stress, exacerbating a flight from funding of banks, he warned.
Now, as noted by Izabella Kaminski, if this specific concern actually happens it would only usurp the financial intermediation services provided to institutional investors. There would still be the retail investor market to conquer. She says this second step could occur if the Fed started issuing e-money for retail customers. That may be a way off, but Kaminski believes it is coming. And she believes the June FOMC minutes indicate the members sees it coming too. Here is Kaminski:
What the Fed seems to be acknowledging is that if its reverse repo programme (RRP) proves too popular it could end up undermining the business of conventional deposit-taking banks. In other words, the Fed is prepping us for the idea that this is the route by which the central bank could become a universal banker… The thing to note, however, is the language and tone being used to communicate these ideas. The message is clearly that the Fed is mindful and fearful of becoming a universal banker and that this is not at all something that it wants.
If all of this comes to fruition I will be worried. The Fed is already a monopoly producer of the unit of account and this would make it a monopoly producer of the medium of exchange too. Monopolies have less incentive and less ability to nimbly respond to changing market conditions. In this case, that means changes in money demand. Unless technology changes so that the Fed is capable of knowing in real time region-specific changes in money demand, it will be applying a one-size-fits-all monetary policy that will intensify regional economic differences. We might begin to think twice about the United States as an optimal currency area. But hey, at least we will all have our own Fed checking accounts!
1 Tomas Hirst and Frances Coppola note that if the Fed does become a universal bank there will still be some private financial intermediation, even if on the margin. So it would not have 100% direct control of the money supply, but close.