"Is the Fed Squeezing the Shadow Banking System? "

From Macro and Other Market Musings:

Some observers believe the Fed's large scale asset purchases (LSAPs) are actually a drag on the economy. They note that the Fed's purchases of treasuries is reducing the supply of safe assets, the assets that effectively function as money for the shadow banking system. They do this by serving as the collateral that facilitates exchange among institutional investors. Critics, therefore, contend that LSAPs are more likely to be deflationary than inflationary. A recent piece by Andy Kessler in the WSJ typifies this view:

So what's the problem? Well, it turns out, there's a huge collateral shortage. Global bank-reserve requirements have changed, meaning more safe, highly liquid securities like Treasurys are demanded instead of, say, Greek or Cypriot debt. And lately, Treasurys have been getting harder to find. Why? Because of the very quantitative easing that was supposedly stimulating the economy. The $1.8 trillion of Treasury bonds sitting out of reach on the books of the Fed is starving the repo market of safe collateral. With rehypothecation multipliers, this means that the economy may be shy some $5 trillion in credit...

[T]the Federal Reserve's policy—to stimulate lending and the economy by buying Treasurys, and to keep stimulating until inflation reaches 2% or unemployment is lower than 6.5%—is creating a shortage of safe collateral, the very thing needed to create credit in the shadow banking system for the private economy. The quantitative easing policy appears self-defeating, perversely keeping economic growth slower and jobs scarce.

So is the Fed really "squeezing" the shadow banking system as Kessler claims? Are the LSAPs actually stalling the recovery rather than supporting it? In a word, no, as this view misses the forest for the trees at two levels. First, by focusing on the Fed's LSAPs of safe assets, this understanding overlooks the more important contributors to the safe asset shortage. Second, this view takes a static view. It doesn't consider the dynamic effect of LSAPs on the supply of private safe assets. Let's consider each point in turn....MUCH MORE

"...The appropriate critique, then, of the Fed is not that it is squeezing the shadow banking system, but that it has failed to do enough to undo the stranglehold on it coming from the shortfall of private safe asset creation and the elevated demand for safe assets...."