‘Operation Twist’ is a contorted mess

Appar­ently never believ­ing them­selves inca­pable of pro­vid­ing much-needed med­i­cine for an ail­ing econ­omy, Fed­eral Reserve offi­cials acted last week to rein­vig­o­rate lend­ing activ­i­ties in the U.S. In a move dubbed “oper­a­tion twist” the Fed will attempt to bring down longer-term inter­est rates while pos­si­bly slightly increas­ing short-term inter­est rates.

How do they intend to do this? Accord­ing to their pol­icy state­ment from last Wednes­day, “…the Com­mit­tee intends to pur­chase, by the end of June, 2012, $400 of Trea­sury secu­ri­ties with remain­ing matu­ri­ties of 6 to 30 years and sell an equal amount…with remain­ing matu­ri­ties of 3 years or less.” As well, the Fed intends to take the prin­ci­pal pay­ments from matur­ing Fan­nie and Fred­die mort­gage backed secu­ri­ties (MBS) it owns and buy more of the same. In all of this the Fed wants to reduce longer-term inter­est rates and help facil­i­tate a bet­ter func­tion­ing mort­gage mar­ket, given the severe prob­lems that per­sist in the hous­ing sector.

And what may be the pos­si­ble effec­tive­ness of such a pol­icy stance over time? Of course, such things are always dif­fi­cult to pre­dict, but a not-unlikely answer is “little-to-none.”

Let’s think about this log­i­cally. To start, long-term mort­gage rates are already at rock-bottom lev­els, with the aver­age 30 year fixed rate loan at just 4.09 per­cent in the U.S. Sup­pose the rate were to drop a few basis points (with a basis point being one-hundredth of a per­cent­age point), per­haps pen­e­trat­ing 4.00 per­cent and going down toward 3.90 percent.

A cen­tral issue becomes how much of a change in the quan­tity of mort­gages demanded will this action pro­duce? In eco­nomic the­ory this involves some­thing called “price elas­tic­ity of demand.” On the lower price-point seg­ment of a demand curve where price is already rel­a­tively low — in this case, the price of bor­rowed money is an inter­est rate — the­ory says that demand is rel­a­tively “inelas­tic,” which means that changes in the price of 30 year fixed rate mort­gages will elicit few added mort­gage loans desired on the part of bor­row­ers. After all, just how many poten­tial home­buy­ers are con­sciously wait­ing for super-low inter­est rates to fall just a bit more? Most prob­a­bly, very few.

As well, con­sider this issue (slightly lower long-term inter­est rates) from the lender’s per­spec­tive. If the Fed is actu­ally able to force long rates a bit lower, will this make sig­nif­i­cantly more bor­row­ers bet­ter risks? Keep in mind, if infla­tion heats up over time due to past Fed mon­e­tary excesses, the “real” return to the finan­cial insti­tu­tion (or the price to the holder of MBS) will fall and they will take a punch on the finan­cial chin. And with huge num­bers of bor­row­ers already under­wa­ter in their mort­gages, will this do any­thing to lead to more refi­nanc­ing and free up con­sumer dol­lars for other pur­chases? Not likely.

Mov­ing beyond just the mort­gage sec­tor, one has to won­der exactly who will be inspired to bor­row funds. While busi­nesses may be iden­ti­fied as a pos­si­bil­ity, medium and large cor­po­ra­tions are already sit­ting on some $2 tril­lion in cash or cash-like equiv­a­lents. This being the case, lower inter­est rates and increased liq­uid­ity from the Fed actions will likely do little-to-nothing to stim­u­late busi­ness loan demand.

Who comes out a win­ner in all of this? It’s hard to pin­point, but the biggest win­ner could be those hold­ing (and want­ing to unload) Fan­nie and Fred­die MBS. And who comes to mind as hold­ers of such assets? Finan­cial insti­tu­tions such as banks, which might still have huge quan­ti­ties of such hold­ings on their books from the mar­ket crash in such finan­cial assets from a few years ago when the mort­gage mess began to unfold. So, the Fed will ride to the res­cue yet again in the name of stim­u­lat­ing the econ­omy, buy up unwanted MBS at or near face value, and allow finan­cial insti­tu­tions to the park the added funds in their excess reserves, which cur­rently obtain a mod­est yield of 0.25 per­cent from the Fed. All-in-all, a pretty good deal for impacted banks.

So, the Fed’s desire to facil­i­tate eco­nomic growth via lower inter­est rates and greater lend­ing are poten­tially short-circuited at each step along the way. And if finan­cial mar­ket par­tic­i­pants begin to fear higher infla­tion from these mis­guided actions, a boomerang effect could ensue (some­times called a Fisher effect) and actu­ally work to drive up long term inter­est rates via higher infla­tion expectations.

Given this, per­haps the Fed’s lat­est pol­icy actions ought to be renamed “oper­a­tion twisted logic.”

Dr. James New­ton serves as chief eco­nomic advi­sor to Com­merce National Bank and is an aux­il­iary fac­ulty mem­ber in eco­nom­ics and sta­tis­tics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not nec­es­sar­ily reflect those of Com­merce National Bank or OSU-Marion/Newark.

Posted by Jim Newton on Sep 27 2011. You can follow any responses to this entry through the RSS Feed. Comments can be made below.