Ever since the HBO series Mad Men conquered the TV screens, the 1960s are back in fashion. Mixing fancy cocktails, wearing hats, listening to the Beatles and the Beach Boys and even chain-smoking are back in vogue. Can the Federal Reserve resist this fad? According to more and more investors and analysts, the answer is no. Meet Operation Twist.
What sounds at first like the name of a martini or a James Bond movie is a monetary policy option explored in February 1961.
After two rounds of quantitative easing, which while stabilizing the US economy didn’t really help to re-boost it, something else must be attempted. Quantitative easing was about increasing the monetary base, providing liquidity to the market and (in QE2) lowering yields on the long end of the interest curve by purchasing government bonds on the secondary market.
In a Washington Post op-ed on 4 November 2010, Federal Reserve Chairman Bernanke explained QE2 as follows: “Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
Two months after the end of QE2, the bottom line is rather sobering to say the least. US unemployment has stalled above 9% with the US economy not creating any jobs in August, the housing market continues to be deeply depressed, credit activity is slim and the gains on the stock market after the introduction of QE2 have already been halved. The main problem with plain vanilla quantitative easing remains the fact that the cheap central bank money is not transmitted to the economy through the credit channel.
Money multipliers, which would show this transmission, remain stuck at their low post-financial crisis levels. Financial intermediaries seem to prefer using the cheap money they can get at the Fed to invest in government bonds instead of lending it to the private sector.
Operation Twist would remedy this. At least this is what many analysts seem to think and why it has become the most hotly debated “new” option of the Fed. In a nutshell, the central bank would issue short-dated bills and use the proceeds to buy long-dated government bonds. By doing so, it would lift the short end of the yield curve and lower the long end, thus entering in direct competition with the financial intermediaries on the government bond markets while at the same time pushing their refinancing costs higher.
Flattening the yield curve is commonly considered to be a more restrictive policy. Spreads, the difference between long and short interest rates, are therefore usually a rather good business cycle indicator because the lower they are the lower growth will be. Why then this counterintuitive measure in an environment of low growth? The reasoning behind such a policy is that with lower government bond yields and higher refinancing costs financial intermediaries will have an incentive to increase their lending activity again instead of investing in government bonds, thus boosting the housing market and firms’ investments.
In theory, such a policy makes sense, but we believe there are several caveats. First and foremost, a policy aimed at getting financial intermediaries to lend more is in blatant opposition to the aim to make those financial intermediaries financially more solid in the aftermath of the financial crisis. It is not a done deal that the balance sheets of many banks have been repaired and cleaned enough to allow them to increase their risks yet again. But even if this would be the case and this is the second caveat, it is not a done deal either, that households and firms will be willing to take more credit again.
Japanese economist Richard Koo, who wrote the seminal “Holy Grail of Macroeconomics” explaining the financial and banking crisis of the early 1990s and the subsequent deflationary stagnation of Japan, is making this argument: “The economics profession has never considered a recession that could be caused by the private sector minimizing debt in order to repair balance sheets after a debt-financed bubble in asset prices. As a result, the profession has no clue as to what is the right thing to do. In this rare type of recession, monetary policy is useless because people with negative equity will not borrow, no matter what the interest rate. Nor will there be many lenders when banks have such huge problems with their balance sheets.”
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