The Fed decided yesterday it would lower the average maturity of publicly-held treasuries by selling $400 billion of shorter-term treasuries and buying the same amount of longer-term treasuries. In addition, the Fed also reconfirmed its commitment to maintain the size of its mortgage holdings and anticipated its targeted interest rate would remain low through mid-2013. The burning question now is how big of an impact will the Fed’s new treasury maturity transformation or “operation twist” program have on the economy? Not much in my view. It should add some monetary stimulus, but like the original operation twist its effects will probably be modest and do little to spark a robust recovery.
So how would it add monetary stimulus? The standard story is that it would transfer duration and other risks from the private sector’s balance sheet to the public sector and thus add to the private sector’s ability to take on more risk. Other riskier assets would be bought by the private sector including corporate bonds and stocks. This would create wealth and positive balance sheet effects that would spur spending. In turn, this would increase demand for credit and banks would start lending more. In addition, banks would be willing to lend more because the Fed’s program would have increased their capacity to take on more risk. Deposits, therefore, would grow and cause the money supply to increase. The Fed’s actions, then, would ultimately result in a larger money supply.
Another way of looking at this is from a monetary disequilibrium perspective. Currently, there is an elevated, unmet demand for safe and liquid assets, mainly treasury bills. This elevated demand for treasury bills has pushed their yield down to zero and made them near-perfect substitutes for money. Because the demand for these safe and liquid assets is not being met by the available supply of treasury bills, it is spilling over into the demand for money assets, the near-substitute for treasury bills at the zero interest rate bound. This creates an excess demand for money that in turn leads to a drop in aggregate spending. The Fed’s new program puts more treasury bills back into the private sector and thus removes some of the overflow excess demand into money assets. It should also raise the yield on treasury bills and make them less of a substitute for money assets. Either way, there should be less of an excess money demand problem and thus more aggregate spending.
Still, I am not sure this new operation twist will pack much of a punch. The reason being is that the Fed is once again adding monetary stimulus without setting an explicit target. Without an explicit target to permanently shape expectations about future spending and inflation, it is hard to see how this new stimulus program will have any more lasting power than QE2. The Fed needs to quit throwing large dollar programs at the economy and instead commit to buying up as many assets as needed until some nominal GDP (or price) level target is hit. This would signal to the public that the Fed is willing to spend whatever is necessary to restore robust aggregate demand. QE2 and the new the operation twist, on the other hand, only commit to spending a limited amount of dollars and after that point, well, the economy is on its own. Nominal expectations are allowed to drift and become unanchored. This is why I find this the Fed’s announcement underwhelming. Wake me up when the Fed really gets serious about doing monetary policy.
Update: Mark Thoma, Brad DeLong, and Bill Woolsey take a similar view on operation twist. Also, FT Alphaville provides a nice roundup of Wall Street views on operation twist. Finally, Edward Harrison does a great code red take on operation twist.
This post originally appeared at Macro and Other Market Musings and is reproduced with permission.