In the search for potential policy tools that the Fed might employ under current distressed conditions, some analysts have floated the idea that the Fed could implement something dubbed as “Operation Twist.” This policy would consist of implementing measures to increase interest rates at the short end of the curve (including sale of short-term Treasury securities) and purchasing Treasuries at the long end in order to lower long-term interest rates.
In this article I want to briefly explain why I believe that an “Operation Twist” is highly unlikely.
I would like begin by quoting current Chairman Ben Bernanke, in a speech he delivered in 2002:
“An episode apparently less favorable to the view that the Fed can manipulate Treasury yields was the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields and lower long-term yields simultaneously by selling at the short end and buying at the long end. Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were not close to zero.”
Having clearly indicated his disapproval of Operation Twist under the sort of conditions that pertain presently (zero interest rates), Bernanke went on to describe the sort of policies he would favor.
“Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.”
Bernanke had good things to say about this 1951 program:
“Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2% on long-term Treasury bonds for nearly a decade ... The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills.
Interestingly, though, the Fed enforced the 2-1/2% ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding.
“To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios.”
In the current environment, raising short-term rates makes no sense. It would raise funding costs for banks, making credit expansion even less likely. Furthermore, it would crimp the profitability of the banks at a time when the Fed needs to promote measures that help banks such as Bank of America (BAC), Citigroup (C), JP Morgan (JPM) and Wells Fargo (WFC) accumulate capital to reduce systemic risk in the banking system.
In an emergency, the Fed is far more likely to implement a “rate cap” or “bond peg” program as described here. Such a policy would lower long-term rates (TLT) while leaving short-term rates near zero.
Disclosure: I am short TLT.
Additional disclosure: I am short TLT and long TBT and SBND.