Operation Twist

By Marshall Auerback and Rob Parenteau

With speculation about QE3 rife, below is a timely explanation of a method the Fed might end up using to target interest rates further out on the yield curve.

The Fed clearly has a dilemma. It needs to finesse expectations management for BOTH Treasury bond and equity investors. Bond investors need to know they are not going to get screwed by inflation, so they want the fed funds rate renormalized. Equity investors want the “extended period” of ZIRP to last for, well, an extended period. Free money is good for specs.

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So what’s a central banker like Bernanke to do?

How about a modern version of “Operation Twist”, which was implemented originally by the Fed in 1961 to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. It was only marginally successful back then.

So why should it work better today?

Well, the Fed has more tools in its policy box, thanks in part to its policy of paying interest on excess reserves (IOER). Scott Fullwiler has an excellent paper on this (“Paying Interest on Reserve Balances: It’s More Significant than You Think”), in which he demonstrates that this change in Fed policy has severed the relationship between the policy rate target and the level of reserves outstanding (if there ever was one – some indications in recent years were that all Fed had to do was announce new fed funds rate target, and primary dealers would take it there, knowing Fed had capacity to change reserves outstanding – all of which meant Fed did not have to change reserves, since they had a credible threat they could, making the textbook story about Fed ops even more outdated and incorrect).

So the Fed can tell everybody that they are renormalizing the fed funds rate and take the IOER up to 100bps. Note, the Fed does not need to remove any reserves to do this – they can just do it administratively. That’s how the IOER works – it severs the link between reserves in the system and the target policy rate, right?

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Then, if the bond gods don’t rally Treasuries on the Fed’s efforts to renormalize the policy rate, Mr Bernanke calls up Bill Dudley (President at the NY Fed) and gives him instruction to buy all the 10 year UST on offer until the 10 year UST yield is down to, oh , say 3.5%. It is an open market operation, which the Fed performs all the time. They won’t have to call it QE, but it is in effect the same thing.

Then, every time some big swinging dick bond trader tries to push it above 3.5% by shorting Treasuries, the Fed slams their face into the concrete by having the open market desk buy the hell out of UST until the 10 year yield is back to 3.5%. Burn Fido enough times, yank his chain enough times, and like the Dog Whisperer, he gets it and stops.

No less than one of the leading “bond market vigilantes” has conceded this point. In his October 2003 Fed Focus, PIMCO’s Paul McCulley has acknowledged that:

“any market induced—foreign or domestic-driven—upward pressure on U. S. intermediate or long-term interest rates would/will be limited by the leash of the Fed’s . . . anchoring of the federal funds rate . . . . Put differently, there is a limit to how steep the yield curve can get, if the Fed just says no—again and again!—to the tightening path implicit in a steep yield curve”.

What happens if the 10 year bond breaks out of the 3.5% to 4% range significantly even with no changes in expectations regarding the Fed? Could that happen, or is there some arbitrage mechanism that brings it back? Of course, there will always be smart bond traders (such as our friend, Warren Mosler), who will understand the potential arbitrage opportunity at hand and react accordingly, but a signal from the Fed that it desires a certain rate level or term structure for rates will facilitate the process.

Operation Twist, Part Deux, then? It strikes us as the optimal way to finesse the expectations management dilemma.

It seems to us that we are now approaching a very critical juncture in terms of potentially settling the debate between those who think that central banks establish the rate structure versus those who believe that this is done by the markets. Of course, like most MMT adherents, we feel that the whole debate would become less relevant if the US Treasury responded to today’s environment through sensible proactive fiscal expenditure, but it’s hard to sustain political support for that amidst sock puppet politicians who dole out goodies to their corporate contributors, and an Administration which genuinely believes we’re “running out of money”.

That places an unnecessarily large burden on the Fed, hardly an appealing prospect, given Mr Bernanke’s own neo-classical economics framework. Keynes himself was quite explicit about the importance of investor portfolio preferences in determining interest rates specifically. Indeed, Ch. 12 of “The General Theory” is all about the beauty contest aspect of asset price determination in the face of fundamental uncertainty and asset markets organized to optimize liquidity for existing holders. Does the Fed understand this? It may well not happen, but no question an aggressive move to counter short term portfolio preference shifts on the part of private investors could do much to resolve this “who determines rates” question once and for all.

There’s a power dimension here. Does the Fed really want to be led around by the nose by the very same people who created today’s economic disaster?

A version of this article was published at New Economic Perspectives in March.

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4 Comments
  1. Scott says

    I have been reading all over the place about Operation Twist, but I don’t believe it is feasible without the FED expanding its balance sheet.

    In particular, Treasuries is just another asset. As the global economy continues to experience a debt implosion in the private sector (and soon to be public sector), the holders of the debt will have to sell some assets to make good on their own debts (the inter-linking of the global economy). One of the assets to be sold will be Treasuries.

    With fewer dollars chasing Treasuries, I expect to see rising yields across the board. The FED can consciously mis-price a specific duration, but there will be too few dollars chasing the Treasury asset class as a whole and some other duration will see higher yields than expected.

    The only way this process will reverse is either with (1) expanded FED balance sheet (2) default re-structurings (though many clever/surreptitious approaches to this exist)

    1. Edward Harrison says

      Scott,

      Rob wrote me to say thi:

      “No reason why Fed cannot buy long end of Treasury curve and sell shorter duration holdings with no net change in total assets held by Fed.

      Fed creates money out of thin air by crediting bank accounts electronically, and will never be a forced seller of assets.

      Treasuries tend to be favored during “risk off” trading period as they are default free, since the government creates the money required to buy bonds in a nation with a sovereign currency. Less liquid, higher risk assets get sold first. Treasury prices tend to get bid up along the way.

      In US nonfinancial corporate sector is net issuing debt again, household debt still contracting, and their is very mild growth in eurozone private debt, so not sure about the assertion of a private debt collapse, although it should show up in the eurozone periphery first.”

  2. flow5 says

    In almost every instance in which John Maynard Keynes wrote the term “bank” in the General Theory it is necessary to substitute the term “financial intermediary” in order to make the statement correct, i.e., the Gurley-Shaw thesis,”Requiem for Regulation Q: What It Did and Why It Passed Away”, etc.

    IOeRs induce dis-intermediation in the money market (which is differentiated by its position on the yield curve (i.e., short-term borrowing & lending with original maturities within a one year period).

    Depending upon the source, IOeRs may reduce the supply of loan-funds, increase the cost of loan-funds, & absorb existing savings. I.e., the IOR policy will exacerbate stagflation.

    Private sector loan demand hasn’t normalized (completely rebounded). The success of any interest pegging policy is of limited duration and is dependent upon stable inflation expectations in the capital markets.

  3. Scott says

    The bid in treasuries is based on a ponzi scheme.  It relies on expanded dollars into the segment.  As far as I can tell there are the following source for expansion in the treasury market (1) FED expands balance sheet (2) other central banks expand balance sheet (3) private sector expands leverage (4) asset reallocation from other market segments.

    The driver of the low interest rates since 2007 has been #1 and #2, which have been unprecedented (and undermining to people’s faith in financial systems).  The continuation of the policies will be politically challenging and would certainly usher the end of the FED (which I believe is likely anyway).  Basel 3 should put an end to #3, though there is always a little room for more cheating until enforcement is real.  #4 is only a short-term feature that would create side-effects that would reduce the amount of #3.

    Here’s a thought experiment.  Let’s say that the US government decided to goose the economy by increasing spending by $2 trillion.  The only way the government could expand their spending (at least under current accounting rules) would be for someone to purchase the treasuries.  I would argue that the mechanisms described in this article constitute options #1 and #3 and would question the political feasibility of it.

  4. Scott says

    The bid in treasuries is based on a ponzi scheme.  It relies on expanded dollars into the segment.  As far as I can tell there are the following source for expansion in the treasury market (1) FED expands balance sheet (2) other central banks expand balance sheet (3) private sector expands leverage (4) asset reallocation from other market segments.

    The driver of the low interest rates since 2007 has been #1 and #2, which have been unprecedented (and undermining to people’s faith in financial systems).  The continuation of the policies will be politically challenging and would certainly usher the end of the FED (which I believe is likely anyway).  Basel 3 should put an end to #3, though there is always a little room for more cheating until enforcement is real.  #4 is only a short-term feature that would create side-effects that would reduce the amount of #3.

    Here’s a thought experiment.  Let’s say that the US government decided to goose the economy by increasing spending by $2 trillion.  The only way the government could expand their spending (at least under current accounting rules) would be for someone to purchase the treasuries.  I would argue that the mechanisms described in this article constitute options #1 and #3 and would question the political feasibility of it.

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