(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)
By Martin Hutchinson
NEW YORK (Reuters Breakingviews) - The Federal Reserve is reviving a 1961 tactic to reduce long-term interest rates, then dubbed Operation Twist. The new iteration is four times heftier than the original as a percentage of GDP. It adds to Fed balance sheet risk and to price pressures; more helpfully, it could somewhat boost small business lending.
The Operation Twist of 50 years ago was devised by future Nobel Prize winner James Tobin and named after the dance craze. It involved the Fed buying $4 billion of Treasury bonds, mainly of one to five-year maturities, while selling shorter-term holdings. It aimed to reduce long-term interest rates while keeping short-term rates high, thereby limiting outflows of gold from U.S. reserves. As it turned out it had no perceptible impact and then Fed Chairman William McChesney Martin later remarked that Tobin’s rationale had been “hopelessly naive.”
At $400 billion, the program the Fed unveiled on Wednesday is equivalent to nearly 3 percent of last year’s GDP, as against less than 1 percent for the 1961 effort. The Fed is also taking on more interest-rate risk by selling short-term paper to buy bonds with longer, six to 30-year maturities. Because the overall size of the Fed balance sheet will not increase, the move is only mildly inflationary. Its principal stimulative effect is supposed to be to bring long-term rates closer to short-term rates, thereby potentially encouraging lending to credit-starved borrowers like small business rather than just purchases of long-term Treasury bonds and near equivalents.
The Fed’s policy is becoming increasingly controversial. Republican congressional leaders rather theatrically wrote to Ben Bernanke, the chairman, demanding he desist from further monetary easing. Perhaps more importantly, three FOMC members dissented from the latest set of decisions. It’s right that Bernanke shouldn’t dance for politicians -- but he should listen carefully to his colleagues.
Another potentially less risky way to bring long and short-dated rates into line would have been by hiking overnight rates. Unfortunately, the Federal Open Market Committee has effectively ruled that out until 2013. In any event, if the old Operation Twist is anything to go by, the new one is unlikely to achieve enough to give Bernanke much to shout about.
-- The Federal Open Market Committee said on Sept. 21 it would purchase, by the end of June 2012, $400 billion of U.S. Treasury securities with remaining lives of six to 30 years and sell an equal amount of Treasuries with remaining maturities of three years or less. The technique is a version of the so-called Operation Twist undertaken in early 1961.
-- The committee also said it would reinvest principal payments from its holdings of mortgage agency debt and mortgage-backed securities in agency mortgage-backed securities, rather than in Treasuries as has been its recent practice.
-- The FOMC kept the federal funds target at zero to 0.25 percent and reiterated that exceptionally low levels would continue through mid-2013. Three FOMC members voted against the policy action.
-- The original Operation Twist 50 years ago was an attempt recommended by future Nobel prizewinner James Tobin to reduce long-term bond rates while keeping short-term rates high to prevent further drainage of U.S. gold reserves to Europe. In 1961 and 1962 the Federal Reserve bought $4 billion of Treasury bonds, mainly those of one to five-year maturity, while the Treasury itself also operated in the same direction.
-- Four months into the policy, long-term rates were unchanged while short-term rates had fallen slightly. William McChesney Martin, the then Fed chairman, concluded that Tobin’s arguments had been “hopelessly naive.”
Editing by Richard Beales and Martin Langfield