Twisting in the Wind
Ben Bernanke’s diminishing returns.
Oct 3, 2011, Vol. 17, No. 03 • By JAMES PETHOKOUKIS
It didn’t take long for the snark attack to begin among the Big Money crowd. Less than 24 hours after the Federal Reserve announced its latest easy-money plan to goose the flaccid U.S economy, investors were already deriding “Operation Twist” as “Operation Fail.” Almost everything that was supposed to go up went down—and vice versa. Global stock markets plunged, oil prices fell, the dollar rose, and inflation expectations tumbled despite the central bank’s decision to swap $400 billion of short-term Treasury bonds for ones of longer duration over the next nine months. It was like Opposite Day on Wall Street.
“If one knew nothing else but simply looked at the market response to what the Fed did [on Wednesday], it would look like a tightening, not an easing of policy,” MKM Partners economist Michael Darda told clients. “We think it’s fair to say that things are not playing out the way the Fed probably expected them to.”
Well, that’s not completely true, nor completely fair. First, understand what’s happening here: Federal Reserve chairman Ben Bernanke is trying to stimulate economic growth by bringing down long-term interest rates—already at multi-decade lows—closer to short-term rates. (What’s undergoing a “twist” is the Treasury yield curve.) With 10- and 30-year Treasuries yielding less, banks would, in theory, have more incentive to use their cash for lending to small businesses and other borrowers rather than buying more government debt. Just as important to Bernanke, lower mortgage rates—which track long-term government bond rates—might add a bit of life to the moribund housing market.
At least that’s the theory. And an untested one it is. The original Operation Twist, a joint Treasury-Fed effort in 1961, was much smaller and had a completely different goal, preventing the flight of U.S. gold reserves to Europe. The results were at best mixed, with former Fed boss William McChesney Martin terming the effort’s rationale “hopelessly naïve.” Even some on the current Federal Open Market Committee are dubious, with three members publicly opposing Operation Twist.
Yet as Fed staffers say, if you see a central banker talking on CNBC and that person doesn’t have a beard, he doesn’t really matter. This is still Bernanke’s Fed, and to the chairman’s likely relief, long rates immediately moved lower on news of the action. So far, so good. Lower rates, though, are intended to be merely a means to an end: encouraging faster economic growth and preventing deflation. That’s what policymakers have really been trying to accomplish by trotting out all these creative monetary tools during the past three years. But it’s just as likely that rates moved lower because of growing investor concern that financial crisis may be about to engulf the global economy for the second time in three years. Last time the spark was dodgy U.S. mortgage debt, this time too much EU government debt. Despite America’s budgetary woes, Treasuries are still the top destination when investors get jittery, pushing rates lower.
Markets have less confidence, though, in the Fed’s ability to do much about either sinking stocks or an American economy dangerously close to sliding back into recession, particularly if Europe goes pear shaped. (Even the Fed concedes that the effect of Operation Twist is “difficult to estimate precisely.”) Few economists think tight financial conditions are the problem right now. The Fed’s already been incredibly accommodating—putting short rates to near zero, two massive rounds of bond buying—with little to show for all that pump priming. The U.S. economy is barely growing, and most forecasters, including those at the White House and the Federal Reserve, think the unemployment rate will stay at 9 percent or higher until 2013. Indeed, the Federal Open Market Committee’s statement last week stressed that there was “significant downside risk” to its outlook.
It certainly doesn’t seem, for instance, that even lower mortgage rates will do much for housing where measures of affordability would suggest the sector should be thriving. It isn’t, of course, not with a huge overhang of existing unsold homes and growing shadow inventory of homes likely to enter the market as mortgage defaults continue. Fear of continuing price drops, along with consumer confidence at its lowest levels since the nadir of Jimmy Carter’s presidency, means there’s not nearly enough demand to sop up that excess supply.
But impotence is hardly the worst-case outcome to Operation Twist, especially in light of an emerging financial crisis overseas that could spread to America. To the extent that the Fed’s gimmicky maneuver works, a flatter yield curve cuts into bank profitability by shrinking the interest margin between borrowing short and lending long. That, along with the impact of Dodd-Frank financial reform, could weaken a U.S financial sector that may soon come under intense stress if its opposite number in Europe begins to implode from the impact of a Greek debt default. Indeed, the Fed’s super-low interest rate policy actually heightens the risk of more market volatility, giving investors access to deep pools of cheap money that can be rapidly shifted between various financial assets.
Markets used to believe in the Greenspan Put, that the Fed would save them in times of crisis. Bernanke has done his best to try and justify that faith. But attendance at the Church of Easy Money is starting to thin, and Operation Twist won’t be the miracle needed to restore the flock or the economy.
James Pethokoukis is a columnist for Reuters.
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