Pragmatic Capitalism

Capital for Living a More Practical Life


The Operation Twist rumors are picking up momentum. In several interviews this morning on Bloomberg both Jan Hatzius of Goldman Sachs and David Rosenberg of Gluskin Sheff mentioned the likelihood of an Operation Twist type QE3 coming perhaps as early as September (thanks to Ed Harrison at CW).

“Best guess for the form of action would be a sort of Operation Twist that is basically like QE – it’s purchases of long-term securities that are financed by the sale of short-term securities.”

If you’re not familiar with Operation Twist, the SF Fed provides the background:

“The Kennedy Administration’s proposed solution to this dilemma was to try to lower longer-term interest rates while keeping short-term interest rates unchanged—an initiative now known as “Operation Twist” in homage to the dance craze then sweeping the nation. The idea was that business investment and housing demand were primarily determined by longer-term interest rates, while cross-currency arbitrage was primarily determined by short-term interest rate differentials across countries. Policymakers reasoned that, if longer-term interest rates could be lowered without affecting short-term yields, the weak U.S. economy could be stimulated without worsening the outflow of gold.”

Will this work today?  It depends on how the Fed implements it.  As I’ve previously described, Fed policy is always about price and not size.  It’s important to understand that altering the size of the Fed’s balance sheet and the amount of reserves in the banking system is unlikely to have any real economic impact as banks are not reserve constrained and asset swaps do not change the amount of outstanding financial assets – QE2 merely changed the duration of savings.   Hence, it was a monetary non-event.

If the Fed were to announce a target rate for the long bond they would essentially be conducting monetary policy at the long end in the same exact manner that they conduct policy at the short end.  If, however, they announce a size for purchases, they would essentially be repeating QE2 – a simple asset swap that doesn’t control the long bond.  This will just flat out not work.  The only way this program can work is if they explicitly set the long bond yield.  If they “finance” (a dangerous term in this instance as it implies a funding constraint) these purchases by selling short bonds (as Hatzius mentions) they would essentially be implementing a curve flattening strategy with the hope that lower long-term rates will be easing.

The crucial point here is implementation.  In order for this to “work” the Fed MUST target the long yield.  If they target a size this program will fail just as miserably as QE2 did.  Unfortunately, the term “work” could be misleading in the event of a yield setting campaign.  If the Fed sets the long bond yield they will essentially be performing open ended QE^n. As they did during QE2, they would correctly tell the markets that they are not printing money, but the likelihood of the public understanding this complex monetary operation is close to nil.

In my opinion, open ended purchases are dangerous in this environment as it could fuel further surges in commodity prices leading to even higher cost push inflation as we saw during QE2. Misunderstanding leads to disequilibrium leads to increased economic turmoil (sound familiar?).   This does not help the broader economy and in fact only further pressures the private sector.  Pinning long-term rates will “work” in that it will suppress long rates, but I am doubtful that the Fed will do this and I am even more skeptical that it will have a substantive impact on the broader economy.  Instead, my fear is that QE^n of this sort will merely induce further cost push inflation which will actually hurt the broader economy by offsetting any positive impact.  The refinancing effect via lower long-term rates will certainly ease debt burdens on some households, but I am not optimistic that it will offset the potential risk of surging commodity prices (the refinancing effect is very focused while the commodity effect is broad across the entire economic spectrum).

On the other hand, the Fed could simply implement this program to repurchase MBS and other assets from the banks.  This would likely help to shore up credit markets (as asset alteration would ease credit fears) during a period when a credit crisis relapse looks like a very real possibility.  This, in my opinion, is not bad policy as it is proactive and could thwart future fears before they spiral out of control (although again, there is the risk of cost push inflation).  This is, in essence, more bank bailouts and unhelpful to the crux of this recession which exists on Main Street.  Unfortunately, QE of this sort (or really of any sort) is unlikely to help generate any sort of sustainable recovery given the uniqueness of this balance sheet recession.  It can cushion the fall, but it can’t build us up.

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