Fed’s Operation Twist Isn’t Much to Shout About
The Federal Reserve has announced its latest effort to jolt the economy back to life. In the widely anticipated move, dubbed Operation Twist, it is pledging, over the next nine months, to sell some $400 billion in short-term government bonds it owns and use the proceeds to buy government bonds that mature in 6-30 years. The theory: this market intervention will help further lower long-term interest rates. The Fed also said than when mortgage-backed securities it owns pay off, it will roll the money back into similar securities. That could help push mortgage rates down.
There are a few reasons why we shouldn't have great expectations for this move.
First, the Federal Reserve moves with all the surprise and guile of a lumbering elephant. It talks about moving, says what direction it might go in and at what speed, and provides a specific date on which it will act. It does so because it wants to avoid spooking the market. But it also means that the market tends to react well ahead of the actual event. Look at the path of the 10-year bond over the last several weeks. The interest rate on the 10-year bond has fallen from 3.2 percent on July 1 to about 1.9 percent today. The mere anticipation of the Fed's move has caused the market to do much of the Fed's work.
Second, given how low long-term interest rates already all - they've fallen by 40 percent in the past three months-- this action is like pushing on a string, or adding another drop of water to a full pitcher. Pick your metaphor. Long-term borrowing costs for creditworthy borrowers are already at Crazy Eddie levels -- they're so low, they're insane. In August, according to Freddie Mac, the average commitment rate on 30-year mortgages it backed was 4.27 percent. Disney in August sold 30-year bonds that yielded 4.375 percent. Google in May sold three-year notes that pay a paltry 1.25 precent in annual interest. The government borrows for 10 years at less than 2 percent. That's all to the good. These lower rates help free up more cash for some people to spend, help corporations paid their bottom line, and lessen the fiscal bite of high deficits. But when you get close to zero, it becomes harder to make a bigger percentage difference. Money simply can't get much cheaper.
In recent years, lower interest rates have generally allowed people who are already able to borrow to do so at lower rates. Homeowners who have a lot of home equity and are current on their mortgages, may be given an opportunity to refinance. But the lower rates haven't generally led to the extension of credit to people who badly need it. If a home is underwater, it's very difficult to refinance., no matter how low rates go. Check out page 9 of Fannie Mae's recent earnings report. The average loan it has been acquiring over the last few years has a loan-to-value ratio of just 68 percent, and only six percent of the loans it bought in that period had a LTV ratio of 90 percent. Meanwhile, value of the collateral for mortgages continue to fall. According to the National Association of Realtors, the median price of an existing home sold in August 2011 was down 5.1 percent from August 2010.
In theory, lower long-term capital costs should lead to filter through the system in the form of cheaper (and hence more plentiful) credit. And banks are finally lending more. The FDIC reportedthat in the second quarter, "total loans and leases at insured institutions rose by $64.4 billion (0.9 percent) during the quarter." That was essentially the first quraterly increase since the second quarter of 2008. The balances of commercial and industrial, auto, credit-card and first mortgages all rose, while home-equity lines and construction loans fell. "A majority of banks (53 percent) reported growth in loan balances in the second quarter." But banks, like mortgage lenders, are still maintaining high standards. The reaction after years of lending recklessly is to be careful, to husband resources, and to not lend unnecessarily.
In their defense, banks generally claim that the demand for credit is low. And across the board, slack demand is plaguing the economy. Unemployment is at a very high level. Those with jobs are saving all they can. Cosumers are reluctant to buy big-ticket items because they remain focused on paying down debt, and are fearful about losing jobs. Companies aren't hiring and investing in the U.S. in part because the demand simply isn't here. This latest moveby the Fed doesn't do much to address that shortfall. Lower interest rates alone can't counteract contractionary forces, like states and cities laying off tens of thousands of people each month, or a poor job market, or wages that don't go up.
There's one item likely to be overlooked in all the discussion over Operation Twist. For the last three years, even as it has made extraordinary efforts to keep money cheap, the Fed has also given banks incentive to sit tight. The central bank requires banks to keep a certain level of reserves on deposit at the Fed. Legislation passed in 2006 permitted the Fed to start paying interest on those reserves starting in 2011. The change was accelerated due to the financial crisis. In October 2008, the central bank announced it would pay interest on those reserves, as well as on reserves posted in excess of the requirements. The amount is small: .25 percent per year. But essentially the Fed provides banks with an incentive to husband resources more carefully. As this data series shows, banks now have $1.57 trillion in excess reserves parked at the Fed, up from $981 billion a year ago. Imagine if the Fed stopped paying interest on those excess deposits. Or if it imposed a penalty on them. Bankers do respond to incentives. And if they had less incentive to lock cash up at the Fed, they might buy bonds, or get a little more aggressive about lending.
The upshot: this move is better than doing nothing. But there's no reason to think it will make the difference between unsatisfying and satisfying growth. The Republican leaders who wrote Bernanke this week to complain that the Fed doing too much about helping the economy shouldn't fret so much.
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