A CNN article speculates that rather than another round of QE, the Fed may attempt "operation twist." That is, try to flatten out the yield curve by selling short-term bonds and buying long-term bonds. Consider first, that a steep yield curve is considered the sign of a healthy economy, and to try to flatten it out would really discourage natural long-term investing, as it would compress the spreads that account for time preference and interest rate volatility risk, the theoretical foundation for why a 1-year bond has a lower interest rate than a 30-year bond. Also, about half the public debt is financed at a term less than 1 year. The median duration of the public debt is 3 years. Governments traditionally finance the bulk of their debt at short-term adjustable rates, not only because the interest rate is lower and they save money that way, but mainly because to do otherwise would spook investors by signaling that the government may be gearing up for a higher inflation/higher interest rate environment. If a government starts restructuring its debt away from short-term rates that would be exposed to an interest rate move, and towards long-term rates that would be well insulated from such a move, the most likely reason is that said government plans on pushing an expansionary monetary policy. That policy would push inflation, and because it encourages all kinds of malinvestment, resource misallocation, and faulty price signaling, nominal rates can't be significantly lower than inflation for any length of time, therefore nominal rates must rise in such a scenario. Such a move would send a stronger signal than when Angelo Mozillo (former Countrywide CEO) was dumping hundreds of millions of dollars in his Countrywide stock right before the music stopped and everything imploded, all while explaining it away as needing to send his grandkids to college.
Imagine you were loaning money to someone who also had the power to change the real value of that money over time (perhaps Ben from my LOST monetery theory thought experiment). You would logically feel more comfortable loaning to someone with this power under terms that required the frequent renegotiation of the interest rate. If after years, actually decades, of loaning money on such terms, Ben came to you and said, "I would like to start borrowing money without renegotiationg the interest rate for much longer this time," it would be cause for concern. The natural question would be, "why?" And Ben's most likely honest response would be, "so that I can transfer real wealth from you to me." You would be disinclined to make such a loan.
QE will be necessary as long as fiscal deficits exceed what traditional lenders are willing to lend. I see the potential for "operation twist" to be in addition to QE, not a replacement of.
Fed May Try 'Operation Twist:' Short- To Long-Term Refi Of Public Debt
August 22, 2011
