Operation Twist 101

(Hemera)

Given the confusion about Operation Twist, here’s an explanation.

What is Operation Twist? Basically the Fed can’t reduce short-term interest rates any further—they’re already at zero.  So they want to reduce long-term interest rates instead.  They do this by buying long-term bonds.  When you buy more of something, you raise the price.  And when you raise the price of a bond, you lower the interest rate.  So what the Fed is doing, is lowering long-term interest rates.

How does the Fed pay for these bonds?  With QE1 and QE2, the Fed effectively just printed the money.  (They “expanded their balanced sheet.”)  Instead, they are selling short-term bonds, and using the proceeds to buy the long-term bonds.  Now selling a bunch of short-term bonds will—usually—lower their price, raising short-term interest rates.  That’s why people call this “Operation Twist”—it should “twist” the yield curve—lowering long-term interest rates (which is what matters when you buy a house, or when a firm borrows to buy new machinery), but it also raises short-term interest rates.

Raising short-term interest rates is a bug, not a feature.  But fortunately, this time, the effect on short-term interest rates will be small.  Why?  The Fed has already committed to keeping short-term interest rates near zero for the next couple of years.  And so given this commitment, the 2-year bond will also be close to zero.

If you watched bond prices move yesterday, you would have seen that the short-term interest rates barely rose, while long-term rates fell a fair bit. So this wasn’t so much “Operation Twist” as simply the Fed reducing long-term interest rates.   In that respect, it’s a lot like QE1 and QE2.  The difference is that the size of the Fed’s balance sheet didn’t much change.

Why ease monetary policy in this new and different way?  Well, it has much the same effect as QE1 and QE2, but quiets many of the critics who were worried that by printing money, the Fed will spark inflation.  I think they’re wrong (and the markets agree with me), but the Fed seems determined to avoid being in the political cross-hairs.  Also, when the public hears about billions of dollars of quantitative easing, too often they misinterpret this as dollars building bridges we don’t need.  QE1 and QE2 didn’t do that.  But Operation Twist is clearer still: The Fed is just swapping one set of bonds for another.

Will it work? There are two levels at which we talk about these things working:

A.     Will the Fed succeed at reducing long-term interest rates?  They already have.  Despite the fact that Operation Twist was largely anticipated, this boost was larger than most expected.  And so in the minutes after the announcement, the 30-year Treasury fell by 13 basis points.  That might not sound like a lot (one-eighth of a percentage point), but it’s one-eighth off, for 30 years!  Those are some big savings.  Also, it’s worth comparing this with how much of a conventional reduction in short-term interest rates would be required to get the 30-year Treasury to fall this far.  The answer is: Quite a lot!

B.     Will this stimulate the economy?  Answer: It won’t hurt.  My own view is that the economy needs all the help it can get right now.  This is a step in the right direction.  I think that an economy this unhealthy needs even more medicine.  So I’m glad that the Fed took this step.  I’m not hoping for miracles, but it will help.

As for the next move for the Fed, I fear that the data for September are looking weak.  And most people are now expecting growth over the next year or two to be insufficient to reduce unemployment by much (if at all).  The Fed is more optimistic.  I think they’ll see more weak data coming, and so will have to move to even more accommodative monetary policy.  Watch for this to be controversial.  I don’t think it should be, but I think the Fed is doing a dreadful job in explaining that what it is doing is much more like conventional monetary policy than they are letting on.

My favorite policy suggestion right now comes from Chicago Fed President, Charlie Evans.  He has suggested that the Fed announce that they are willing to tolerate higher inflation until the unemployment rate falls below some level.  Why not make it clear: We want unemployment to fall below 7%, and we aren’t going to fret if pursuing that goal causes inflation to temporarily rise to say, 4%?  I know not everyone will like this, but the suffering caused by today’s unemployment is surely larger than that caused by a little inflation.  Indeed, many economists believe that a little bit of inflation would help consumers work their way out of their current debt overhang.

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  1. Abe says:

    Justin,
    Why should be believe that a rise in inflation will cause a decrease in unemployment? Why should we re-visit the efficacy of the Phillips curve?

    You are asking the Fed to decrease real wages by 2% on the HOPE that the Phillips curve will work and short-run employment will rise. But over the long-run, it’s clear that employment and inflation have virtually no correlation. You cannot cause employment by inflating the currency… So your proposal seems like a bad bet to me.

    Cordially,
    Abe Froman – The Sausage King of Chicago

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    • AK says:

      The Feds uses a bs inflation number anyways, so its probably not going to matter much. You say it would decrease wage by 2%, but is inflation really only 2% right now? The Fed numbers don’t include food costs, and gas prices. Well gas is around $4 bux a gallon and box of cereal is $4 bux compared to like low $2s for both like 6 years ago. I’d say real inflation rate has increased quite dramatically, and is already affecting real wage by quite a bit.

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  2. Blorf says:

    Everything always sounds so rosy when the central planners pull their strings. Perhaps you could include a frank discussion of potential unintended consequences of yet another market intervention?

    Let’s start with banks, who make money borrowing short term and lending long term. Raising short term rates and lowering long term rates cuts their margins. You may have noticed bank stocks tanking when the policy was announced.

    Their balance sheets are already a shambles with lord-knows what manner of non-marked-to-market assets. The fed has now cut deeply into their potential revenue sources. When we have the inevitable banking crisis in the next year, I hope anyone advocating this plan has the decency to admit their mistake, insofar as this twist layers on another dose of unintended consequences.

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  3. Sal M. says:

    When you wrote:

    Now selling a bunch of short-term bonds will—usually—lower their price, raising long-term interest rates.

    did you mean:

    Now selling a bunch of short-term bonds will—usually—lower their price, raising short-term interest rates.

    ?

    - Sal M.

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  4. DavidR says:

    “The Fed has already committed to keeping short-term interest rates near zero for the next couple of years. ”

    So, how exactly is the Fed going to accomplish this? Just saying it doesn’t make it so. That’s not how the world or markets work. QE3 (or whatever they decide to call it) here we come.

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    • ak says:

      They control the interest rates…..all the fed has to do to keep short term near 0 is do nothing. don’t raise the interest rates.

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  5. James says:

    Wolfers certainly takes a clearly one-sided look at things. I love Freakonomics.

    Wolfernomics, not so much.

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  6. John B says:

    Interest rates are not the problem. They are incredibly low on a historic basis.

    If a business can’t make money at very low rates, it won’t make money at slightly lower rates.

    If a person can’t make mortgage payments at 5%, they won’t be able to make them at 4%.

    If this is all that the fed has left, we are in real trouble.

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  7. Inflationhater says:

    Sooner or later the Fed will realize this won’t work, they will keep monetizing the debt, with so much money printing the Wiemar republic will look like nothing… better start hoarding beans and ammo, and maybe a few kiloTons of Gold.

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    • DAB says:

      Hidden due to low comment rating. Click here to see.

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  8. Matthew says:

    The Fed not sparking inflation due to their printing money depends on how inflation is defined. The fear of the Fed printing money causing inflation is based upon the idea that more money will be in circulation facing an unchanged pool of goods and prices will trend upwards at a pace proportional to the excess supply. You state that the markets “agree” with you, and you take as proof the fact that bond prices have not risen as they would were continuing inflation feared. Despite the unchanged bond yields, price inflation, especially in food is quite evident. What gives?

    The truth is that it isn’t that the Fed dumped dollars into the economy, it is *how* they did it. The Fed purchased Treasury Bonds from the large investment banks like Goldman Sachs. In driving up the price and the yields down the Fed has made fixed income investments decidedly unattractive from a return standpoint. As a result, the money available following the sale of the bonds had to move into other assets classes, of which only three others exist: real estate, equities and commodities. The real estate market is still declining and unworthy of investment so the money looking for return went into equities and commodities. As a result, the S&P 500 more than doubled from its March ’09 lows and commodities like cotton have seen a rapid “step up” in pricing as money moved from Treasuries. These moves are not based on consumer demand however, and are being artificially propped up by the money not being invested in bonds.

    This is Bernanke’s true fear: if interest rates rise money will come back out of these asset classes and pricing will collapse, sparking deflation and an instantaneous Depression as money flow comes to a grinding halt.

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