The Fed considers a contorted exit strategy from stimulus

September 25, 2013, 6:46 PM UTC
Ben Bernanke

FORTUNE — Ben Bernanke may have to pump up the shadow banking system in order to stop manipulating the bond market. At least that’s how some see it.

For months, there has been talk inside and outside the Federal Reserve that the U.S. central bank might have to use an unorthodox method to exit its bond buying program. That could be even more accurate now. On Monday, four days after Bernanke announced the Fed would put off winding down the program — the so-called taper — New York Fed president William Dudley said the U.S. central bank was testing so-called reverse repos as one method to eventually increase interest rates.

In reverse repos, the Fed drains money from the economy by having banks, money market funds, and others give it money overnight for a fee. It’s kind of like a loan, but not quite. The Fed gives banks Treasury bonds as collateral. The rate on the repo effectively sets short-term interest rates, because why would anyone make a loan for less when the Fed is willing to pay risk-free?

That’s not how the Fed typically raises interest rates. Historically, it has sold Treasury bonds to drive up rates. But that may no longer work because the U.S. central bank now has over $3.5 trillion in Treasury and mortgage bonds. It would take much more selling than usual to move the market. What’s more, to calm market fears about its bond buying program, Bernanke essentially pledged that the U.S. central bank would never actually sell the bonds.

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Dudley stressed it was just a test. But the longer the Fed’s bond buying goes on, the more likely the Fed will eventually have to deploy reverse repos or something like it.

The reverse repo plan comes at a time when a number of Fed governors have talked about the need to rein in the repo market and other areas of the shadow banking system. Repos are generally considered part of the shadow banking system because the loans are so short that they generally don’t get recorded in overall leverage measures of the banking system. What’s more, a lot of repos are made by money market funds, which are technically not banks. Just last week, Fed governor Daniel Tarullo said regulators should focus on cracking down on short-term funding markets.

“It’s ironic that they would do this at a time when a number of people in the Fed had said they are worried about repos,” says Burt Ely, a bank consultant.

Tarullo, however, is chiefly worried about banks using the repo market to get short-term loans to fund longer-term riskier assets. Many believe the use of short-term funding made the financial crisis worse.

Initially, the Fed’s plan wouldn’t do that. Banks, along with money market funds, would be making loans to the Fed. But the Fed’s program is bound to draw a lot of money to the repo market. And that money is unlikely to leave after the Fed program is over, at least not immediately. The next likely user of those short-term funds: banks.

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Another concern is that the Fed’s use of the repo market might crowd out General Electric (GE) and other large companies that rely on money market funds for borrowing. Big corporations might have to pay a higher interest rate for their short-term loans to compete with the Fed. That, of course, is the point. The Fed is trying to raise interest rates. But with the Fed borrowing so much, borrowing rates for big companies could shoot up more than expected. The result is a market that’s jumping from one artificial correction to another.

“The Fed is jumping into the repo market to fix problems that were caused by quantitative easing. What you get is more and more markets where prices are not being set by investors but by the Fed. We are losing the market’s normal price discovery system,” says market strategist James Bianco. “Fed officials will say these concerns are misplaced, but they always say that.”

Of course, the fact that the Fed put off tapering means that it will be longer until the Fed actually raises interest rates. So there is nothing to worry about, yet. But the longer Fed waits before calling off its stimulus efforts, the more likely it is that we will have to worry about it someday.