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"Let’s Do the Twist:" The Feds Latest Strategy

Written By:
September 22, 2011 at 12:35 PM

Despite an appeal from the four ranking Republican lawmakers not to continue its stimulus policies of intervening in the economy, the Federal Reserve Board announced that it would proceed with a plan to drive down long-term interest rates. The scheme: sell $400 billion worth of Treasuries due to mature over the next few years, and use the proceeds to buy Treasuries that come due six to 30 years into the future.

The plan -- “Operation Twist,” was named for the strategy pursued by the Kennedy White House in the early 60s. It cut long-term interest rates and maintained a “hands off” policy for short-term interest rates. The strategy of selling short-term Treasuries and buying long-term Treasuries, to drive down long-term interest rates, is called “twisting the yield curve.”

The thinking behind this move: drive long-term interest rates even lower. Make historic cheap, even less expensive to consumer and business borrowers.

Who can refuse that offer?

According to the official statement released by the Feds, the move will “help make broader financial conditions more accommodative." The will began in October and expects to end by June 2012. The strategy does not increase the money supply. So far, the economy has an annual growth rate of 0.7 percent for 2011. The “official” unemployment rate stands at 9.1 percent. Some place the unemployment rate closer to 22 percent.

The three Federal Reserve Board regional bank presidents, Charles Plosser of Philadelphia, Narayana Kocherlakota of Minneapolis, and Richard Fisher of Dallas, opposed the Operation Twist decision out of concern it will result in a higher inflation rate. The same three bankers expressed dissent at the August meeting when their colleagues made the decision to keep the federal funds rate low for the next two years. The federal funds rate refers to the interest rate lenders charge other banks to borrow money overnight, which help them meet reserve requirements

Effectiveness Questioned

When the Feds made the decision to hold their September meeting over a two-day period, market watchers figured something was in the works. Hence, the announcement of Operation Twist did not come as a surprise to many.

Critics of the move do not buy into the assumption consumers and businesses will have more incentive to spend and borrow money. The various strategies -- buying Treasuries and quantitative easing, implemented over the last few years support this point of view. Even with low mortgage rates and attractive commercial borrowing rates, the stimulus strategies have been a dismal failure.

In the letter to the Feds, co- signed by Speaker John Boehner of Ohio, House Majority Leader Eric Cantor of Virginia, Senate Minority Leader Mitch McConnell of Kentucky and Senate Minority Whip Jon Kyl of Arizona, the Republicans wrote, “We have serious concerns that further intervention by the Federal Reserve could exacerbate current problems or further harm the U.S. economy. Such steps may erode the already weakened U.S. dollar or promote more borrowing by overleveraged consumers. To date, we have seen no evidence that further monetary stimulus will create jobs or provide a sustainable path towards economic recovery.”

Republican presidential contender, Governor Rick Perry of Texas, said in August that more bond buying by the Feds would nearly constitute treason.

In the spirit of partisan bickering that has engulfed Washington D.C. since the Republican takeover of Congress, the Democratic Senator from New York, Charles Schumer categorized the letter as “an attempt to meddle in the Fed's independent stewardship of monetary policy.”

Possible Effects on Housing Market

The Feds believe by reinvesting principal payments from its portfolio of Treasuries and mortgage-backed securities shores up the mortgage market. A segment of the investment community believes Operation Twist as a positive for the housing market. Furthermore, if the Feds did not intervene, housing values could have at least an additional loss of ten percent.

Operation Twist helps put the sector on a more stable footing -- even if it does nothing to stimulate other sectors of the economy directly. Investors who have been shorting the housing market may have to adjust their investment approach if home values finally reach bottom.

Some economists say the plan would reduce long-term interest rates by 0.2 percent. Yale economics professor, and one-half of the widely used S&P/Case-Shiller home- price index, Robert Schiller, states that extremely low interest rates do not influence homeowners when they are “lacking confidence.” Schiller also touches on a theme that has plagued the economy for the last three years -- high unemployment and the lack of job security for employed homeowners.





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