Fed Could Do The Twist...Again (Guest Post)

Graphic Source: CNNMoney

By Ilene

Adapted from Phil's Stock World:

While world markets sell off, and President Obama and Congress wrangle over some form of job-creating legislation, the Federal Reserve is busy with its own problems as it attempts to deal with stubbornly high and persistent unemployment. Expectations for additional quantitative easing (QE) are running very high, but there is the possibility that the Fed may undertake a different kind of QE program, designed to provide stimulus without actually putting more money into the system.


One widely discussed possibility would be to replay the famous 1961 “Operation Twist” action, where the Fed used open market operations to shorten the maturity of public debt in the open market. By buying longer-term bonds, the Fed will cause price of those bonds to go up, and this will drive the longer-term yields down. Selling shorter-term bonds (to fund the purchase of the longer-term bonds) will put pressure on the price of the shorter term bonds, while driving short term yields up.

According to Bloomberg, “the Fed may decide at its Sept. 20-21 meeting to replace short-term Treasury securities in its $1.65 trillion portfolio with long-term bonds in a bid to lower rates on everything from mortgages to car loans... The Fed’s influence on the economy will probably be muted as sagging consumer confidence, depressed home values and 6 million workers unemployed for six months or more weigh on demand.”

Theoretically, driving down longer-term interest rates should help boost the housing market and consumer spending. However, this is another top down approach, and many doubt it would significantly effect the economy. As John Silvia, chief economist at Wells Fargo, noted,

“The problem is that rates have been low for three years now and that isn’t spurring people to buy. Companies won’t hire unless demand is there. The Fed can lower the cost of credit, but it can’t force companies to create jobs.” 

Rob Hosking summarized the situation:

"Dr Bernanke 'has no real policy options left that he did not use already last year and that with hindsight had no discernable economic impact,' Mr Walters [JP Morgan Australia and New Zealand economist] says. The stimulus did have a financial – as opposed to an economic – impact and one of those was to drive up the value of other currencies, the New Zealand dollar being one of them. Instead, there is a growing expectation the Fed will perform an updated version of Operation Twist, a move first performed in the early 1960s and named after a dance craze of the time.

Under that move, which ran between 1961-65, the Fed bought up long-term US Treasury bonds and sold short term bills, in a bid to flatten the yield curve, and thus help the housing market, but to do so in “sterilised” way that did not expand the money supply.

The move was widely regarded to have failed at the time, although recent academic work suggests it was more effective than was realized. 

But Operation Twist is not a money printing campaign. Describing details about how Operation Twist will work, Emily Flitter suggests it would take some "fancy footwork" and the New York Fed would probably have to hold two auctions in a single day. The Fed would sell shorter-dated securities in a first auction, and then hold another auction to buy bonds with longer maturities. These auctions would both settle the following day.

"While it would lower rates at the back end of the yield curve, Operation Twist could also nudge front-end rates higher, possibly to the benefit of money market funds scrambling for ultra-safe securities with a yield above zero.

"The way we looked at it, it looks like they could sell something like $265 billion -- everything they hold through June 30, 2013 -- and that could be absorbed with very modest rate movement," said Thomas Simons, money market economist at Jefferies & Co in New York.

"It might push rates a few basis points higher" in shorter-dated Treasuries, he added.
Goldman's Hatzius said such an operation would ultimately remove so much longer-dated debt from the market, its effect would be almost as big as the Fed's last major easing program." 

According to Bill Gross and Mohamed A. El-Erian at PIMCO, more stimulus from the Fed might have an adverse effect on the economy by driving up commodity prices.

“The balance between the benefits and cost and risks has changed in an adverse manner,” El-Erian said. “At the end of the day we will not be solving anything. We’ll just be undermining the economy and a critical institution for the well being for America.”

Governments should be focusing on creating growth rather than reducing debt, Gross said. “To do it right now is almost suicidal,” he said. 

Whether the Fed begins another round of quantitative easing (QE3) or deploys another form of intervention  the likely reality is that the Fed has no genuinely viable options remaining to help it achieve its dual mandate of maximum employment and stable prices, as established by the Federal Reserve Act. Instead, the Fed has been reduced to promoting politically expedient "solutions" in the face of a moribund global economy suffering from persistent and intractable unemployment.

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The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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