Is the Fed Going to Revive JFK's Operation Twist?
The markets took another sickening leg down this morning, with the Dow Jones Industrial Average breaking down to the 10,800 range as fears France may be downgraded shot through Wall Street.
And now Street talk is putting pressure on the Fed to do something, after it released its Federal Open Market Committee statement yesterday indicating a sharp negative revision to its economic outlook, and noting it would keep the fed funds rate low at least through mid-2013, amid unusually high dissension from some of its voting policy makers.
The Fed, though, did not indicate it would extend its debt-monetization policies, where the Fed has already bought $1.6 trillion in Treasuries, and nearly $900 billion in mortgage-backed securities, helping to blow out its balance sheet to $2.9 trillion.
It may not need to, as the 10-year note is now breaking down toward an unheard of 2% as investors flee to this safe haven. That will help drive mortgage rates lower in a moribund housing market.
But what about keeping it there permanently, to revive the deadweight housing market thats behind all this economic chaos and a possible double dip in 2012?
Is Operation Twist 2.0 just around the corner?
Thats what economists and traders are now talking about. The Fed could still re-enact a version of Operation Twist from the 1960s, nicknamed after the dance move made famous by Chubby Checker (its second round of quantitative easing mirrored this program).
To battle a recession back then, upon taking office, President John F. Kennedy convinced the central bank to sell short-term Treasuries and use the money to buy long-term bonds, described by San Francisco Federal Reserve Bank researchers Titan Alon and Eric Swanson,
The move sought to ramp up yields on shorter bills, which would attract capital from overseas and backstop the dollar.
And buying longer-term bonds would hopefully lower long-term Treasury yields to stimulate long-term investments, which San Francisco Federal Reserve Bank researchers Alon and Swanson say it did, by 15 basis points.
In doing so, JFK and the Federal Reserve sought to battle "cross-currency arbitrageurs," who were converting U.S. dollars to gold (the U.S. was still on a gold standard then), and using the proceeds to buy higher-yielding European assets, Alon and Swanson note. Gold was pouring out of the U.S. into Europe, at several billion dollars per year, alarming the White House. Operation Twist involved the auction of just $6.9 billion in new 18 month, short-term debt, with the proceeds going into purchases of notes at least five years in maturities.
Because it was so small in scope, it was difficult to judge its success and so got mixed reviews. However, Bernanke mentioned Operation Twist in a famous 2002 speech about the dangers of deflation before the National Economists Club in Washington, D.C., where he also noted the benefits of a money-financed tax cut is essentially equivalent to Milton Friedman's famous 'helicopter drop' of money.
Heres what Bernanke said back then:
An episode apparently less favorable to the view that the Fed can manipulate Treasury yields was the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields and lower long-term yields simultaneously by selling at the short end and buying at the long end. Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were not close to zero.
And heres what he also said:
Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.
Bernanke applauded this program: Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade.&The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding.
To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios.