Fed Readies Reverse Repo Hoping To Soak Up QE Cash

Everyone, it seems, loves asset inflation. What could be more satisfying than watching the value of your home, your stocks, and your 401(k) soar, especially after the economic beating from the mortgage meltdown? Monetary illusions that pass for prosperity buy Washington time to tackle other Big Problems, like providing affordable health care to everybody, eliminating income inequality, bringing peace to the Middle East, and saving the planet from global warming.

But woe to the powers that be if the asset bubble pops and rampant inflation follows. Paying more for gas, groceries, and rent as wages stagnate, housing prices collapse, and retirement savings erode makes voters grumpy. This is a threat to incumbent politicians—especially if they have not meanwhile solved the aforementioned big problems. They can try to shift blame to mysterious forces beyond their control, but this is becoming increasingly difficult as mainstream media loses its ability to enforce Washington orthodoxy.

And so, the world’s greatest mysterious force—the Federal Reserve—has to figure out how to wean the global economy off of Quantitative Easing before it unleashes a tsunami of liquidity as trillions in excess reserves flee too-big-to-fail bank balance sheets seeking better returns than the few measly basis points earned parked at the Fed.

The Fed, of course, could begin selling off its massive hoard of securities, expunging the money that buyers surrender in return. The problem is that this would tank the sovereign debt and mortgage securities markets, potentially generate huge losses for the Fed, compromise Uncle Sam’s ability to borrow, and make life miserable for Fannie Mae and Freddie Mac. So, we can expect the Fed to hold those assets to maturity.

What’s a central planner to do?

Not incidentally, the operation will also provide the repo market with trillions in top quality collateral, the mother’s milk of the shadow banking business. The hope of the fiat currency cabal is that the end of QE will not necessarily spell the end of the financial machinations it enabled. Here’s why.

Shadow banks use the repo market to manufacture money much the way FDIC-backed fractional reserve banks pyramid deposits via commercial lending, at least before skittish businesses stopped borrowing and bankers learned they could make higher profits placing proprietary derivatives bets. While the Volcker Rule is supposed to put a stop to that, this will hardly dent the shadow banks. By shoveling fresh hyper-hypothecated collateral into the synthetic derivatives’ maw, notionally piled $693 trillion high as of the last survey, the bonuses can continue to roll.

Turning the Fed from the lender of last resort into the borrower of first resort may sound bizarre, but when a fiat currency system gets this out of control central bankers have to find ever more clever ways to keep the runaway train from flying off the rails. Given the short term nature of repo market lending, a massive rollover operation will have to be spun up to make sure all that cash stays tied up. In the long run, all of the loans will have to be paid back, presumably by extracting $4 trillion from taxpayers as the Fed’s government bond portfolio matures.

How Congress manages that feat is a problem for another day. The big question is: Can this process be managed without interest rates spiking back up to Carter-era levels?

If all this sounds like musical chairs, that’s because it is. The only difference is that if the Fed lets the music stop, the illusion of prosperity we’re seeing will stop along with it.