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Last updated: October 3, 2011 7:29 am
Communication is an important aspect of monetary policy. When announcing a new policy, it is best if policymakers sound as if they think it will work.
On September 21, the Federal Reserve announced its intention to purchase $400bn of long-dated Treasuries and sell an equivalent amount of short-term securities. It said the programme “should put downward pressure on longer-term interest rates”.
A clear statement, but unfortunately one that is at odds with Ben Bernanke’s previous thoughts on the subject. In a 2004 Fed paper written with Vincent Reinhart, Conducting Monetary Policy at Very Low Short-Term Interest Rates, the Fed chairman stated: “Whether policies based on manipulating the composition of the central bank balance sheet can be effective is a contentious issue ... changes in relative supplies within the range of US experience are unlikely to have a major impact on risk premiums or term premiums.”
The policy has been tried before, in 1961, when the Fed attempted to reduce long-term rates to stimulate the economy while keeping short-term rates high to prevent an outflow of reserves. This attempt to “twist” the yield curve gave the policy its name – Operation Twist – which the market has adopted again. At the time, the original Operation Twist was deemed a failure, although a 2011 paper by Eric Swanson of the Federal Reserve Bank of San Francisco estimates that long-term Treasury yields fell by 15 basis points as a result.
History suggests, therefore, that the policy works to a limited extent and the current version has had some initial impact.
Immediately after the announcement, 30-year Treasury yields dropped sharply and the yield curve between two-year and 10-year Treasuries flattened markedly, but both have subsequently retraced much of those movements. At the time of writing on September 30, the net decline in 30-year yields was approximately 20bps, while the 2s/10s yield curve was 10 basis points flatter. The impact on rates, of course, would probably be greater if the Treasury was not gradually increasing the average maturity of its debt issuance.
But will a fall in interest rates of this magnitude make any difference? Lower long-term rates provide an incentive for mortgage refinancing – helped by the Fed’s decision also to buy more mortgage-backed securities. Lack of mortgage demand, however is a larger problem than the price of money. A flatter yield curve, meanwhile, hurts banks’ profitability, reducing their incentive to refinance mortgages. Cheaper money might help large companies lower their cost of borrowing, but for small businesses credit risk is a bigger obstacle to obtaining financing.
The most probable outcome is that Operation Twist lowers long-term rates slightly and flattens the yield curve a bit, but this will have little impact in kick-starting the economy.
This begs the question of what will the Fed do next, and here Mr Bernanke’s 2004 paper is instructive as it shows what options the Fed believes it has.
When short-term rates are at or close to zero, Mr Bernanke describes three alternative policy tools the Fed can use. The first is to provide assurance to financial investors that short rates will be lower in the future than they currently expect: the Fed has already said economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The second alternative is to increase the size of the central bank’s balance sheet beyond the level needed to set the short-term policy rate at zero, ie quantitative easing, which has also been tried. The third option is to shift the composition of the central bank’s balance sheet – the recently announced Operation Twist.
Having pulled all three unconventional monetary policy levers, the Fed is running out of options.
Mr Bernanke’s 2004 paper also refers to the Fed’s efforts between 1942-51 to set rate ceilings at different points on the yield curve. The Fed might consider dusting off this policy, and direct attempts might well lower yields, but would still be “pushing on a string” with regard to economic impact.
Trying to cap yields would also entail further quantitative easing and expansion of the Fed’s balance sheet and for now the Fed has spurned the “more of the same” option. This may reflect recent Republican political pressure against further stimulus, but the Fed will have to ignore interference with its independence and consider quantitative easing before long.
The Fed’s basic problem is that, whatever it tries, monetary policy is likely to be of limited effectiveness in a liquidity trap. The fiscal policy alternative is not under the Fed’s control and, given the size of the US budget deficit, stimulus will not be forthcoming.
With Operation Twist the Fed wanted to communicate that it has options to stimulate the economy. What it has communicated is the depth of its concerns about the weakness of the economy. It is the resulting fear of double-dip recession, as much as changes in the composition of the Fed’s balance sheet, that will continue to send long-term yields significantly lower.
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