Operation Twist 101
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.