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“Operation Twist”…Again

In 1961, during the Kennedy administration, the Federal Reserve launched something called “Operation Twist”. The program was intended to encourage investment by lowering long-term interest rates, and attract foreign capital by holding up short-term rates. It wasn’t considered particularly successful then…which leaves us to question how it will fare today.

Last week, the Fed announced another “twist”. The plan is to buy $400 billion in long-term Treasuries (6 to 30 year remaining maturities), and pay for them by selling an equal amount of short-term securities (under 3 years). When the Fed buys long-term Treasuries, it will influence rates by increasing the price of bonds (when bond prices rise, bond yields fall). And selling securities in order to buy other securities means the Fed does not have to expand its balance sheet …it is instead extending the maturity of its balance sheet.

And looking at the yield curve, lowering long-term rates is the only option the Fed has…it’s not possible to lower short-term rates any more than they already have.

The idea is that lowering long-term rates will “help make broader financial conditions more accommodative”, according to the Fed’s statement. And those accommodative conditions come in the way of lower rates on things ranging from mortgages to business loans. Lower borrowing costs will be an incentive for consumers and businesses to borrow and spend.

It’s a great idea, in principle. The problem is that, in practice, it won’t have much of an impact.

That’s because low interest rates aren’t the answer to the problem. And that’s because Interest rates are not a growth constraint for the economy. Rates are already at historic lows, and that hasn’t done much for borrowing/lending activity. Borrowing (and lending) is about confidence. And that’s what consumers and businesses are lacking.

You can lead a horse to water, but you can’t make it drink. And the Fed can lower long-term rates, but it can’t make consumers want to borrow or make banks want to lend. The Fed’s intention is to “support a stronger economic recovery” by shifting the maturity of its balance sheet… but unfortunately, this ‘twist’ doesn’t translate to economic activity.


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