Operation Twist

Bernanke

Just when we thought (and hoped) the Federal Reserve might have shot all its bullets (without hitting the target by the way), it turns out  there are plenty left.  The latest to garner attention, after Chairman Bernanke's mention in his much anticipated Jackson Hole speech, is "operation twist," an action last carried out in 1961 during the Kennedy administration.  It lowered longer term rates back then by .15% and raised shorter-term rates marginally.

Doesn't sound like much, but when employment is stalled at zero net job creation and GDP is anemically bouncing along at 1%, the Fed will try anything.

What is "Operation Twist"?

The Fed's usual modus operandi is to manipulate short-term interest rates by controlling the federal funds rate.  Federal funds are borrowed and lent by banks to meet their reserve requirements.  Banks can also buy or sell Treasury securities to meet reserve requirements, and so the Fed's manipulating of the fed funds rates affects other rates as well.

In fact, typically rates all along the maturity spectrum - the so-called yield curve are affected.


"Operation Twist" seeks to carry out this impact directly by changing the composition, instead of  the size, of the Fed's balance sheet.  The plan is to sell shorter maturity Treasury bills and buy longer-term Treasury notes.

The idea is that longer term yields will drop - specifically the rate on 30-year fixed rate mortgages.

Likely Impacts

Markets anticipate.  On Friday, the yield on the 10-year Treasury dropped to below 2% and the yield on the 2-year Treasury note rose 2 basis points.  Dealers and others want to position themselves ahead of the Fed's move.  This is similar to the carry trade that heats up when the Fed announces it will keep short-term rates low.

Secondly, the Fed will likely find itself loaded up with longer term securities at the lowest point in yields. When the inevitable rise comes, it will have on the books significant underwater positions.

Thirdly, this action, like much the Fed does, ramps up uncertainty.  What can I say to a client who asks if now is a good time to take a mortgage?  Very likely, by the Fed's manipulating longer term yields, 30-year mortgage yields could be lower in the near future.  Market observers believe the policy could be formally announced at the 9/21-22 Federal Open Market Committee meeting.  With the uncertainty, it is better to just sit on the sideline and wait.

Finally, this is another slap in the face to those who live off of fixed income.  The already anemic rates on such things as 3- and 5-year CDs will decline further.  But, hey, it's for the good of the bankers and we all have to sacrifice ( I'm getting ready for Obama's speech on Thursday!).


 

Why Macroeconomic Policy Doesn't Work

This morning we got an anemic employment report, as expected, with a slight pickup in the unemployment rate. This comes after, in effect, throwing the kitchen sink (in terms of fiscal and monetary policy) at the economy.

On the fiscal policy front, the Bush tax cuts have been extended and a payroll tax cut has been enacted along with a massive stimulus program. On the monetary policy front, short-term rates have been driven to zero and two massive programs of monetizing the debt, known as QE1 and QE2, have been carried out. The end result of these policies have been a record deficit of $1.4 trillion, a national debt equal to the GDP production of a year, a bloated Federal Reserve balance sheet, a sinking dollar, and a protracted fight over increasing the debt limit.

And still, the economy limps along. How can this be? Why isn't macroeconomic policy working?

The answer, IMHO, goes deep into misinterpreting British economist Keynes, the inevitable arrogance that power brings, and a basic misunderstanding of economics.

Let's start with the basic misunderstanding of economics. Controlling prices distorts resource allocation. This is Econ 101. Instructors put up the well-known minimum wage graph and show the unemployment that results. Instructors put up the graph of rent control and explain that, over time, rent control destroys cities.

Then they go teach their macroeconomic class and somehow fail to grasp the long run consequences of the Federal Reserve controlling arguably the most important price in the economy - the price of short-term money.

Take a quick look at the past decade during which, in 2003, the federal funds target rate under former Fed Chairman Greenspan was driven to 1%, during a strong housing market. This poured gasoline on a fire. The housing market took off on a moonshot. The labor force poured into the home building market, the mortgage creation industry, and, yes, the financial services industry of securitizing exotic mortgages. In other words, controlling prices and jerking them around have real consequences.

The Fed then turned around a year later and systematically, as shown on the graph ( CLICK TO ENLARGE), pushed short-term rates sharply higher. This caused the housing market, which was speeding ahead at 110 miles an hour, to slam head-first into a wall. In real terms. all of sudden the home builders, real estate agents, etc., were superfluous.

These are people, many of whom would have finished college with a degree in another area, satisfying a legitimate economic need - not one artificially created by a Fed controlling the price of short-term money. And today people need to be retrained in a world that has become considerably more complicated. Putting people back to work takes a long time in today's technologically driven world.

The story for fiscal policy is just as depressing. John Maynard Keynes, in The General Theory of Employment Interest and Money (arguably the most influential book of the 20th century), outlined a specific strategy for countering a severe economic downturn. It justified deficit spending during such periods. Unfortunately, politicians have used the justification to spend irresponsibly during all phases of the business cycle. This brought us into the present situation already with a massive debt and a large deficit. In other words, there were holes in the roof before it started to rain.

Even the man in the street knows that fiscal policy programs have to be paid for. Politicians have ignored this basic principle and now are willing to bring the U.S. to the brink of default, surely causing Alexander Hamilton to spin in his grave.

The programs lead to spending, but they don't retrain people for the types of jobs that are now available.

Where does the arrogance come in? It clearly is a power trip for those who have taken it upon themselves to set the price of short-term money. Former Chairman Greenspan was at the point of changing the rate practically every time he forecasted a change in the overall economy. It is reminiscent of former Soviet Union economic planners.

And many have argued that the Fed Chairman is the second most powerful person in the world. In fact, this is probably true - unfortunately, this power is hurting millions of American families.

What is Monetizing the Debt?

On Friday DIY Investor looked at how the Federal Reserve puts money into the economy. Interestingly, just yesterday he saw a commenter somewhere ask the age old question of where does the Fed get the money to buy securities. The answer is - out of thin air. And this is the problem.

In many areas of life when a screwup occurs there is a choice. People have to pay for their screwup or they are bailed out. Many times it depends on where the screwup happens to be on the economic spectrum. At the lower income part of the spectrum, for example, a job loss can be a catastrophe. Towards the upper end not so much.

One function the Federal Reserve has taken on is bailing out the financial system when it screws up. This of course is the whole "moral hazard" /too big to fail issue.Our biggest financial institutions including investment banks, rating agencies, and even auditors thumb their noses and take excessive risks. They know they'll be bailed out.

The Federal Reserve's  "lender of last resort" function has morphed over time (thanks mostly to former Fed Chairman Greenspan) into a " lender whenever there is a small bump" function.

On Saturday DIY Investor described how the Fed and the Treasury are different. In basic terms Treasury borrows for the Federal government to fund its chronic deficit. Just like any corporation, it issues bonds. To see the actual issuance check out the Bloomberg Calendar where the weekly auctions of bills, notes, and bonds are listed. Treasury borrowing is only a problem in that it "crowds out" private sector borrowing and, in turn, this bcomes an issue as the economy moves towards full employment. It will push up interest rates and thereby worsen the deficit problem.

The real issue is when Treasury borrows and the Fed buys the issues it is selling. This is called "monetizing the debt". The two ballyhooed "Quantitative Easing" programs were basically just old fashioned "monetizing the debt" programs but they couldn't be called that. Certain phrases like "bailout" and "monetizing the debt" are not typically used in polite company.

What does monetizing the debt do? Simply it creates high powered money or what is officially called the monetary base. This is the stuff that bankers hold and use for their part to create money out of thin air. When they create money out of thin air it lowers the value of money. Just like anything, when supply increases, price drops. In terms of the monetary unit this is inflation. When your grandmother said the dollar doesn't buy what it used to it was just her way of saying there has been a lot of inflation.

Now you're probably wondering what the monetary base looks like today. Wonder no more:

The bottom line is this: banks have the potential for explosive growth in the nation's money supply. They have an incentive as well - banks earn profits (and they are profit maximizers like every other business all though that might not be obvious from recent experience) by making loans, i.e.creating money out of thin air.

Chairman Bernanke's press conference was basically to keep markets from freaking out over signs that inflation is picking up. He is attempting to inject confidence in the market as commodity prices skyrocket. He is trying to send a message that the Fed is in control.

All of this is reminiscent of 2006 when he was a leader in the ongoing refrain that the housing crisis was a localized event and wouldn't have a major impact on the broader economy.

Brett Favre: Please Make a Decision

Since this week has been about some behavioral science/decision making stuff, I couldn't pass up this Dan Ariely guest post on Brett Favre's retirement decision process at Econgirl's site. Sports fans will enjoy the interactive graphic.
Those who haven't seen it should watch the 17-minute TED talk by Dan Ariely where he asks "Are we in control of our own decisions?"