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The Federal Reserve announced last week that it will undertake a second Operation Twist. Under this plan, the Fed will sell some of its remaining shorter-term Treasury securities, those under three years in maturity, in order to buy longer-term Treasuries with maturities greater than six years. We don’t think this will add to growth. In its June 20 statement, the Fed explained its thinking behind these policies:
This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative.
Yet quantitative easing and the first Operation Twist haven't provided much, if any, stimulus to the economy. The biggest result of the Fed’s duration purchases has been to distort bond markets, hurt savers, and misallocate capital. These are some of the factors causing the economy’s very poor growth performance. The latest purchase announcement is not likely to work any better, since the beneficiaries of low long-term interest rates already have a great deal of access to low-rate funding. Fed Chairman Ben Bernanke gave a similar and more detailed rationale for buying longer-maturity bonds in his November 4, 2010, Washington Post opinion piece, writing:
Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
It simply hasn’t worked. The problem is that total private-sector credit didn’t grow much in 2010 or 2011, while the government and big corporations increased their borrowings substantially. The losers were small and new businesses that received a smaller credit ration. The Bank for International Settlements released a major study in late June criticizing quantitative easing and explaining its ineffectiveness. The study argues that quantitative easing policies fail to deliver growth because, in part, markets are forward-looking and have to worry about how central-bank asset purchases will be unwound. Our own explanations of the likely damage to growth from these Fed policies are laid out in Wall Street Journal articles on October 19, 2010 (“How the Fed Is Holding Back Recovery”), and on December 4, 2009 (“Near-Zero Rates Are Hurting the Economy”). The latter article explained the problem: “Capital is being rationed not on price but on availability and connections. The government gets the most, foreigners second, Wall Street and big companies third, with not much left over.” Among our other objections to the Fed's twist policy of selling shorter-term securities while buying longer-term securities is that the Fed is buying duration at the very peak of the bond bubble. Longer-term Treasuries are already in very short supply, meaning high prices and low yields. The market for long-duration high-quality bonds like Treasuries is hot because: 1) Treasury has been shortening the duration of its issuance at a time when it should be issuing long to take advantage of the low yields; 2) with many European sovereigns no longer considered riskless, the universe of super-high-grade bonds — prized for collateral, insurance company ratings, derivative markets, etc. — has shrunk; and 3) the Fed is competing head on with the bond-hungry aging populations in the industrialized countries and China. The original Operation Twist was a $400 billion Fed purchase of duration. This twist is a $267 billion operation by year-end 2012. These are large buybacks relative to the supply of long-duration bonds. The result is a risky reduction in the effective maturity of the marketable national debt to 41 months, as shown on the graph. Another problem is that the Fed is running out of its own liquidity to undertake this kind of duration shift. Holdings of 91-day to one-year Treasury bills stand at only $26 billion, down from a recent peak of $131 billion in October 2011. The Fed’s “quick ratio” (short-term assets compared to current liabilities) has fallen to just 1% from a normal of 20%-25%, and will likely be pushed lower by the next twist operation. In this calculation, we’re comparing the Fed’s 91-day to 1-year holdings to the sum of currency plus the required and excess reserves owed to banks. This gives a good measure of the Fed's ready liquidity. On the positive side, it’s good the Fed didn’t try to do even more in its June meeting (i.e. QE3 or a bigger Operation Twist). We worry about the day when markets perceive that the Fed is taking its last shot.
2012 Economic Growth Fellow
David Malpass is president of Encima Global, and chairman of GrowPac. He writes a regular Current Events column in Forbes magazine, and his opinion pieces appear regularly in the Wall Street Journal. He sits on the boards of the Economic Club of New York and the National Committee on U.S.-China Relations. Formerly, Mr. Malpass was chief economist of Bear Stearns. Between February 1984 and January 1993, he held economic appointments during the Reagan and Bush Administrations. He was Deputy Assistant Treasury Secretary for Developing Nations, a Deputy Assistant Secretary of State, Republican Staff Director of Congress’s Joint Economic Committee, and Senior Analyst for Taxes and Trade at the Senate Budget Committee.Full Bio
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