OPERATION TWIST AGAIN

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

This should have been my second critique of government reactions to the economic downturn.

2. Operation twist again

After its March 18 meeting, the FOMC stated that it had decided to purchase “up to $300 billion of longer-term Treasury securities over the next six months.” This decision followed a speech by Chairman Bernanke on Dec. 1, 2008, indicating that “the Fed could purchase longer-term Treasury securities … in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand.”

DanielThornton, The effect of the Fed’s purchase of long-term securities on the yield curve,” Federal Reserve Bank of St. Louis Economic Synopses, May 18, 2009.

There was a brief decline in long rates, but the yield curve soon regained, and surpassed, the steep slope of mid-March. The Fed’s failure to alter relations between yields on these highly substitutable securities has a long history. In 1961, President Kennedy indicated the importance of “increasing the flow of credit into the capital markets at declining long-term rates of interest to promote domestic recovery” while “checking declines in the short-term rates that directly affect the balance of payments” (Economic Report of the President, 1962, p. 50). The Federal Reserve was directed to twist the yield curve by buying long-term securities to lower long rates while selling short-term securities to raise short rates.

This policy flew in the face of the expectations theory of the term structure, according to which investors maximize expected returns. In a linear approximation of the simple case of default-free U.S. securities, investors are indifferent between 1- and n-year securities if

Long rates are averages of current and expected short rates, where prescripts denote expected 1-year rates i = 1, 2, … periods in the future. Relations between current long and short rates depend on expectations. Given expectations, a fall in Y_n while Y₁ rises must be reversed as investors shift to the suddenly more profitable shorts. Operation twist could have worked only if expectations of future rates were simultaneously lowered, contradicting the announced policy of higher short rates. Uncertainty interferes with perfect substitutability, but the policy was inconsistent and impossible.

The administration indicated its satisfaction with the yield curve’s twist (Economic Report of the President, 1966, p. 86), but the figure shows that it behaved normally (or twisted a little less than usual) during the 1961-65 economic expansion. The tendency of yield curves to flatten during expansions (because long rates are less variable than short rates) has continued in recent years.

An example of the lengths to which the Fed must go if it is determined to influence the yield curve contrary to expectations was given by the interest-rate peg of World War II. The Fed stood ready to buy and sell 3-month and long-term governments for 0.375% and 2%, respectively. At the peg’s end, the Fed held no long-terms and virtually all the short-terms. Official efforts to manipulate relative prices are futile, and destroy markets if pursued vigorously.

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References

John Wood and Norma Wood. Financial Markets. Harcourt Brace Jovanovich, 1985.

Elmus Wicker. “The World War II policy of fixing a pattern of interest rates,” J. Finance, June 1969.