The Federal Reserve’s decision to extend its Operation Twist program out to the end of this year seems to many observers to be a fairly benign attempt to keep some juice flowing into a skittering US economy. There were some market observers who were calling for an outright quantitative easing program (most likely dubbed as “QE 3”) to be launched, but the Fed was not ready for that sort of ammunition. So the continuation of Twist seemed a palliative approach to appease those arguing for more monetary stimulus.
Operation Twist is a program where the Fed “trades” its short term notes (mostly US treasury bills of 3 years or less duration) in for longer duration notes and bonds of somewhat greater risk (on average). The duration of US treasuries purchased is a minimum of 7 years and as long as 30 years. In addition, the Fed program will continue to acquire mortgage-backed securities and other long-dated mortgage type paper in an attempt to keep mortgage rates low and stimulate a mostly moribund housing market and slowly expanding business community.
Singer/dancer Chubby Checker delighted audiences some 50 years ago with his dance songs called “the Twist.” The Fed’s Operation Twist derives its name from that dance.
Recent economic reports show a slowing US economy on many fronts from jobs to retail store sales to regional industrial activity reports. A lot of the blame can be placed on the financial mess in Europe as well as fear that China’s exports are hurting due to the European recession. Furthermore, as this is a presidential election year where both parties remain polarized over many issues, it seems to many observers that nothing of importance will occur between now and the election in November. Also, with fears of what “America’s Fiscal Cliff” dilemma could do to this country during the period of the lame duck Congress, the Fed has decided that some form of monetary stimulus must remain in place until the end of this year to try to over-ride the effects of weak fiscal stimulus from the US government.
In his meeting with the news media after Wednesday’s Fed announcement, Chairman Bernanke said that by the end of this year, the Fed’s balance sheet would reflect almost no short duration debt assets (in banker’s parlance, debt instruments are actually called “assets”). Almost all of the debt that the Fed expects to hold by January 2013 will be long-dated maturities. The Wall Street Journal points out in its June 21st edition that the Fed’s balance sheet will be approaching $3 trillion, and almost none of that debt paper will be short-term maturities.
When one sharp reporter asked Bernanke about the state of the Fed’s balance sheet and how that affects the Fed’s ability to stimulate the economy to meet its jobs mandate, Bernanke admitted that the extended duration of the balance sheet would limit any further action with a balance sheet strategy–his eyes shifted from right to left as if to imply he didn’t know where to go from here. Hastily, he added a wishy-washy answer “that we would have to take other kinds of steps to create stimulus in the economy.” He shifted nervously in his chair after making that statement. For me, this was the key moment of the last few years of Fed policy! (You can see it and hear it at about the 40 minute mark of this C-Span video.)
Bernanke quickly moved on to another question before any reporter asked for further clarification. Not one reporter (save perhaps the one from The Economist who asked the question) in the room seemed to grasp the immense meaning of this remark–or at least they did not wish to pursue it. The big question in my mind became, what are these “other kinds of steps?”
In short, without boring you dear reader, the implications of the extension of Operation Twist leads me to draw the following conclusions, and not necessarily in this order, but rather as random thoughts that rush into my mind…
1) The Fed intends to keep short-term interest rates near zero until at least year 2016. Up to now, the Fed has explicitly said that short-term rates will remain near zero until late 2014, and in one of my previous blogs, I spelled out the real reaons why the Fed had made this unprecedented announcement to keep interest rates low to a future target date many months off. Yet, as the Wall Street Journal points out, the Fed’s balance sheet will not have any sizable maturing assets until January 2016 due to all the longer-date maturities it will have on its balance sheet. So, how can the Fed begin to raise short term interest rates if it will have no short term paper to sell? Indeed, Mr. Bernanke admitted in the June 20th press conference that “large asset purchases increase the size of the balance sheet…and makes an exit a more extended process.” Therefore, in translating this Fed-speak, I predict that before too long, Bernanke will announce that short term interest rates will be kept low through for at least another year beyond the previous target (well into year 2015 and possibly into early 2016). The reason will be that the Fed will be trapped in a corner with virtually no ammunition to fight rising interest rates before then –but the Fed will not give this as an official reason as it would cause panic in the markets. Instead, the excuse will be blamed on a continuously weak economy.
2) OK, so if the Fed has no short term paper to sell, should it need to raise interest rates sooner, it will have only one real option: it could sell the long-dated paper on its books. The problem with this strategy is very dangerous for two reasons: first, the selling of long-dated maturities would force up the cost of mortgages and capital loans to businesses, thus choking the economy as well as possibly fueling more inflation (as long bonds with rising interest rates are usually the barometer for higher inflation) and this would do little to stop the fuel of inflation which requires interest rates to rise on shorter-term paper. Additionally, if the Fed sells any meaningful amounts of this long-dated paper, it basically exposes itself to mark-to-market values for those bonds, thus exposing the Fed to insolvency since the Fed has little capital on its balance sheet compared to the debt it holds. What would the world think of an insolvent central bank that stands behind the world’s main reserve currency? The answer to this question would not have a pretty result, I fear.
3) In the same Wall Street Journal story, the reporter said that the Fed could always print more money
to work its way out of a corner–this raised my eyebrows, since printing more money is inflationary to the economy. Sure, if the economy remains weak and deflationary forces remain, then printing money (quantitative easing) is certainly a tool that remains for the Fed. However, in a scenario where the Fed confronts future inflation, money printing would not be an option. There is also the basic mechanical problem to consider, which is the Fed would have no short term paper to sell back into the market which would force up short term interest rates and thus slow inflation, as one of Bernanke’s predecessors (Paul Volcker) did so brilliantly in 1980 during a very inflationary time in the US.
So, here I harp again, but I foresee this Fed strategy as quite risky in the long run for our economy. As I have elaborated before, China is doing just the opposite of the Fed, in that it is trading its longer-dated US maturities for our short term paper. In other words, as the Fed sells the short term debt, China is most likely one of the biggest buyers of this debt. At the same time, we know from the Fed’s own published reports, that foreign buyers appear to be buying less of our longer-dated debt in the past year; while the Fed is the largest de facto buyer of this type of debt which foreign buyers seem to want less of.
In that same Wall Street Journal edition of June 21st, another report indicated that China was preparing to open up its markets more to foreign investment (including its stock market) as it works toward making its currency one of the global reserve currencies (currently the US dollar and the Euro are the two main world reserve currencies). China intends to create a liquid bond market in Chinese sovereign bonds and its stock markets. In other words, China is working in a very obvious way to position its yuan to assume the role of reserve currency for the world by year 2020, I believe, if not sooner.
If the Fed is boxed in a corner should inflationary pressures build before 2016, it will have no bullets to fight inflation. Should the Fed attempt to sell its long-dated paper in an attempt to absorb some demand from the economy, then that would choke off certain parts of the economy while also exposing the Fed to insolvency. This would put China in the cat-bird’s seat as it would create a new flight to safety toward Chinese bonds and other investments should its markets be at least partially developed by such time.
There would also be a flight to quality, in my opinion. That flight to quality would be to the world’s one asset currency….gold (and it’s sister currency, silver). In this scenario, I can foresee gold doubling or even tripling from today’s price near $1,560 an ounce.
The Fed chairman has remarked many times that his strategy with Operation Twist as well as Quantitative Easing is an experimental one. Indeed, all past leaders of the Fed followed a much more conservative strategy of owning mostly short term treasuries and some short term high-grade corporate debt. No Fed, except this one, has chosen to experiment in such a way with long term debt and with debt of questionable quality (mortgage-backed securities as example).
The one thing that strikes me the most is that the financial media and our leaders in Washington seem to not understand what a grand experiment this has all been….and I fear, this is one experiment that should have been tested more in the laboratory of our economic schools before being unleashed into the real economy. If a chemist took his experiment out of the lab before seeing the potential results, would that chemist not cause great trouble for his community?
Perhaps things will all work out and my fears are overblown? I’m sure many who read this blog will think so. Well, there would be one easy way out for the Fed…if the economy were to truly remain weak until year 2016 and the velocity of money remain weak too, then the Fed might possibly be able to get out of the fix it is already into. If this is to be the result, then is all of this talk about monetary stimulus just a lot of noise and a waste of time and resources?
Now I begin to understand how we may be repeating the lost two decades that Japan has experienced…is not the safest and best solution for the Fed to see us going down the same road as Japan has done? Sadly, a zombie economy for years to come may be the safest solution.