Wednesday, September 21, 2011

The Twist

Today the Fed announced that it would embark on 'Operation Twist', as the business press has dubbed it. To be a bit more precise, here's the actual text from the FOMC press release:
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
What does this mean? Basically, it's an effort by the Fed to bring down long term interest rates. Typically the Fed moves interest rates by changing the intercept of the yield curve, i.e. by shifting the entire curve up or down. It can do this because it has control over short term interest rates, and that anchor can shift the rest of the yield curve up or down.

But one of the many odd things about being at the zero lower bound on interest rates, as we have been in the US for a couple of years now, is that the Fed no longer has the ability to shift the yield curve down. So the 'Twist' is an effort to bring down long term interest rates despite this handicap. As shown in the picture below (which is meant to be schematic, not exactly accurate), by selling short-term bonds and buying long-term bonds, the idea is to change the slope of the yield curve instead of its intercept.

Some observers, like Mark Thoma, have suggested that while laudable, this effort won't actually accomplish very much. And I'm sympathetic to that point of view, because I agree that in an ideal world, the Fed would be doing much more than this to try to help spark an economic recovery in the US.

But as I've argued before, I do think that any reduction in long-term interest rates can only help -- and the US can use all the help it can get right now. But more importantly, we have to recognize the fact that the Fed is now operating under the cloud of very real and very dangerous political threats.

Those threats are now being made, contrary to all historical precedent in the US, because of the way the American public has voted over the past few elections. And those threats impose real constraints on the Fed's ability to act.

Given those constraints, this is a pretty good response, I think: it embodies a balance between doing something that would actually help the economy (which is, I'm convinced, what the FOMC would do much more of if politically unconstrained), and not doing so much that it creates a political backlash that would have serious negative consequences for the Fed's long-run independence.

So if we are unhappy that this is the extent of the Fed's efforts -- and I think we have every right to feel that these efforts are inadequate -- then I think it is important to explicitly recognize that these actions by the Fed are insufficient due to political constraints. The conduct of monetary policy should clearly be added to the list of victims of the current toxic political environment in the US.

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