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What Twists Will We See from the FOMC Tomorrow?

Victor Nava and Anthony Randazzo
June 19, 2012, 1:36pm

Rumors are flying everywhere that the Fed is going to ease policy again after its meetings today and tomorrow. The Financial Times declared yesterday that "the doves are ready to act." And a report in Forbes suggests that more Fed easing is likely to come sooner rather than later, in the form of an extension of the Feds Operation Twist program. JP Morgan Chase and Barclays are also both expecting the FOMC will extend the $400 billion dollar (to this point) bond swap program known as Operation Twist.

These rumors are not terribly unexpected. Nor would Fed action tomorrow be shocking. The economy has been deteriorating this year steadily and financial markets have been tightening up. Chairman Bernanke has reiterated time and again this year that the Fed was willing to act if it needed to, but that they wanted to wait to see if their previous QE efforts could help recovery take hold. No such luck so far though.

More than two months ago Reason's James Groth predicted that rising yields in long-dated treasury bonds would likely lead to a new bond purchasing program or an extension of Operation Twist. It is looking like this is going to put more QE very much back in the cards—if not tomorrow then in coming months, as the global economy and U.S. economy are not going to hit an upswing soon. 

To date, 30-year US Treasury Bond yields have only gone down 9 basis points since the bond swap program began in October of 2011, and at many points during the programs original run 30-year US Treasury Bond yields were actually higher than before the program started. With economic conditions slowing (Barclays forecasts Q2 GDP to grow only 1.8% and May saw only 69,000 new jobs added) it's not surprising that this Fed would seek more easing.

One possible wrinkle, mentioned in the Forbes piece, in the program were it to be extended is that the Fed could move to purchasing more mortgage-backed securities and fewer treasuries (in order to limit the impact on the treasury market). If this turns out to be the case, you can add "a slowing of housing prices declining to normal levels" to the laundry list of Operation Twists negative side-effects.

The rest of the list (as illustrated by Dallas Federal Reserve Bank President Richard Fisher), first blogged about here:

  1. "Embarking on an Operation Twist would provide an even greater incentive for the average citizen with savings to further hoard those savings for fear that the FOMC would be signaling the economy is in worse shape than they thought. They might view an Operation Twist as setting the stage for a new round of monetary accommodation-a QE3, if you will. Such a program was considered redundant by business operators given their surplus of undeployed cash holdings and bankers' already plentiful excess reserves. In addition, such a program might frighten consumers by further driving down the yields they earn on their savings and/or lead to long-term inflation that would erode the value of those savings;
  2. The earning power of banks, both large and small, would come under additional pressure by suppressing the spread between what they can earn by lending at longer-term tenors and what they pay on the shorter-term deposits they take in;
  3. Pension funds would have to reassess their potential returns, with the consequence that public and private direct-benefit plans would have to set aside greater reserves that might otherwise have gone to investments stimulating job creation;
  4. Expanding the holdings of the Fed's book of longer-term debt would likely compound the complexity of future policy decisions. Perversely, the stronger the economy, the greater the losses the Fed would incur as interest rates rise in response and the prices of those longer-term holdings depreciate. The political incentive to hold rates down might then become stronger precisely when we want to initiate tighter monetary policy. This concern, of course, would be a good news/bad news issue: The good news is that it would stem from a stronger economy; the bad is that might hurt our maneuverability and, in doing so, might undermine confidence in the Fed to conduct policy independently."

Something that had not escaped some analysts is that the above discussion didn't factor in where inflation is at. As the FT shows in a chart, a number of inflation indicators are heading downward or hovering around 2 percent. However CPI has been on steady march up and hasn't slowed down since the middle of the first quarter of 2012. Concerns about economic and financial conditions could overshadow inflation fears at the FOMC meetings this week, but most are expecting some kind of action tomorrow. 

We'll have to wait for news tomorrow, but in the mean time, please ponder why since the "twist" dance went out of style 60 years ago, why this approach to monetary policy can't go out of style as well? 


Victor Nava is Research Assistant

Anthony Randazzo is Director of Economic Research


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