Wed, September 21, 2011
Will The Federal Reserve Bring Back The Twist?
The financial press is buzzing with rumors that the Federal Reserve will try to boost economic activity by revisiting actions it took in 1961. At the time, the move was known as “Operation Twist.”
Last month the Federal Reserve announced that it intends to keep interest rates low until the middle of 2013 if the economy remains weak. The Fed had the option to engage in another round of “quantitative easing” – a maneuver in which it increases the money supply in order to buy bonds and depress yields. But the Fed decided to hold off on “QE3,” perhaps because it wants to keep such an action in reserve in case things get really bad – or perhaps because QE1 and QE2 were fairly controversial.
Since the economy continues to be sluggish, the Federal Reserve may attempt some other means to reduce unemployment and encourage economic growth. Fed Chairman Ben Bernanke has publicly floated suggestions of what the Fed “might” do. Given his propensity for tossing out hints about future Fed activity, attention has become focused on an idea that he’s mentioned a few times: increasing the maturity of the Federal Reserve’s portfolio. This is what was done in the sixties’ Operation Twist. A growing number of economists and Fed-watchers are predicting that a new Operation Twist will be announced by the Fed after its two-day meeting ends today.
The Federal Reserve currently has a balance sheet of about $2.7 trillion, including about $1.5 trillion in Treasuries, $500 billion of which will mature by 2014. If the Fed were to begin selling its short-term Treasuries and buying longer-term ones as it did in the 1960s, in principle, the yield on short-term bonds should rise and that of long-term bonds should fall. This is because selling bonds tends to depress their prices, and bond yields move in a direction opposite to bond prices. This kind of activity, if done on a large enough scale, could cause the difference between short- and long-term rates to narrow.
Currently, 2-year Treasuries yield about 0.20% and 10-years yield 2.15%. The margin between the two is already narrow, but the hope would be that lowering long-term borrowing costs will induce consumers and corporations to borrow money and make longer-term investments.
There are reasons to doubt that this action, if taken, will boost the economy much. In order to take the risks associated with borrowing, borrowers must feel positive about the future. With the US economy still weak, political gridlock in Washington, and likely sovereign defaults on the horizon in Europe, economic optimism is in short supply. Moreover, US corporations are sitting on $2 trillion in cash that is yielding essentially zero; if they want to spend money, they don’t need to borrow it. There are also doubts as to whether more borrowing is really a large-scale solution to our economic malaise.
It will be interesting to see whether the Fed goes in this direction, but even if it does it will bring little joy to most consumers. A new Operation Twist will not give savers higher interest rates, though it might entice a few more people to buy houses.