Operation Twist: The Fed’s QE3

Well, the FOMC didn’t call it QE3, but it’s pretty close.  For those with short memories, QE1 and 2 were the “quantitative easing” programs in which the Fed purchased large quantities of non-traditional securities, including U.S. government bonds and mortgage-backed securities.  After Wednesday’s FOMC meeting, Ben Bernanke announced that the Fed would take another shot at “operation twist.”  What they’re trying to twist is the yield curve.  But they don’t want to add to inflationary pressures, so they need to keep the money supply relatively constant.

And what they’re proposing may work.  The Fed will sell $400 billion of Treasury bills and other short-term government debt.  At the same time they will purchase $400 billion of ten year U.S. government bonds. Net change in the money supply: $0. The idea is that the increased demand for long-term bonds will push the price up and the interest rate down.  Other long-term rates (mortgages, corporate bonds, maybe even longer-term municipal bonds) should also see their yields fall.  Lower borrowing costs will probably induce a bit more borrowing in the long-term debt markets.

Parenthetically, I have to wonder about the three FOMC members who voted against this.  In the past their dissent has been based on fears of inflation.  But this new policy does not change the money supply.  That should have eased their concerns, but apparently did not.  We’ll see what the markets say.  If long-term interest rates drop, the Fed’s policy has worked.  However, it’s also possible that inflation expectations might rise, causing those same interest rates to rise.  Watch the behavior of those long-term rates carefully over the next few weeks.

Is it enough to fix the U.S. economy?  No way.  Long-term interest rates are already very low.  According to the Wall Street Journal, AA corporate bond yields have varied between 2.60 and 3.44% over the last year.  As of 1 pm Pacific Time, the yield was 2.91%.  Companies like Microsoft and Google that have traditionally shunned debt have issued billions of dollars in long-term bonds to take advantage of this situation.  The problem is not interest rates.  The problem is a lack of aggregate demand.  And aggregate demand won’t recover until the unemployment rate falls considerably.  I’ve argued elsewhere that the unemployment rate will remain high until some of the regulatory uncertainty emanating from Washington, D.C. is resolved.

The Fed is doing everything they can.  But monetary policy really is like pushing on a string.  Without demand pulling at the other end of the string, it won’t move much.  Neither will the economy.

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About Tony Lima

Retired after teaching economics at California State Univ., East Bay (Hayward, CA). Ph.D., economics, Stanford. Also taught MBA finance at the California University of Management and Technology. Occasionally take on a consulting project if it's interesting. Other interests include wine and technology.