Thursday, September 22, 2011

The Fed and "Operation Twist"

As was widely expected, the US Federal Reserve announced today that it would employ “operation twist”, whereby it will lengthen the duration of its existing balance sheet holdings by selling short-dated securities and purchase longer-dated maturities. The Committee intends purchasing $400b of Treasury securities in the 6-30 year part of the yield curve and selling an equal amount of Treasury securities with remaining maturities of 3 years or less. This programme is intended to exert downward pressure on long-term interest rates.

There had been some speculation the Fed may adopt further measures such as reducing the interest rate paid on excess reserves. They did not adopt that today. The Committee has decided to reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage backed securities.

The Fed effectively adopted a bias to ease at their last meeting in August. Statements since then, including Chairman Bernanke’s speech at Jackson Hole signalled a high likelihood that they would do something and so it quite soon. The only questions were what “it” would be and how effective “it” would be.

“Operation twist” can be seen as a compromise solution by the Fed. There is a range of opinion at the Fed about the need for further stimulus. In particular the “hawks” did not want to see further balance sheet expansion. We agree with them. As it stands, three members of the Committee voted against today’s actions.

On the question of efficacy, we remain sceptical about the ability of the Fed to do much to influence stronger economic growth. As we have said before, monetary policy cannot do this alone. That’s because monetary policy can’t do much to influence the necessary structural rebalancing in the US economy, although a weaker exchange rate is helping in that regard. Thankfully we have started to see some (small) supply-side measures in President Obama's jobs plan. More of that would be good.