Will Operation Twist Just Leave Us Twisting?

With increasing calls for Fed activism, , President and majority owner, Farr, Miller & Washington, LLC presents a compelling case for the Fed to do less, which he calls “Come on Baby, Let’s Do the Twist.”

Mr. Farr opposes the Fed’s commitment to additional stimulus by extending the size and duration of its existing “Operation Twist” program, whereby the central bank sells its short-term bond holdings and uses the proceeds to buy longer-term bonds. The Fed has committed to buying an additional $267 billion in long-term Treasuries by the end of 2012.

Twist vs Quantitative Easing

So far, it doesn’t appear that Twist has been effective in getting banks to lend. Bank lending  fell in the first quarter of this year, and is up only 1% from what it was in the three months before Twist was launched. That may make sense given how weak the economy has been, but in terms of the Fed’s stimulus program, that’s not a great twist.

Mr. Farr takes it a step further, arguing that Federal Reserve stimulus will actually impede recovery. This is a decidedly contrarian view to that of many economists, who believe that the economy could use all the fiscal help it can get and Bernanke’s latest effort to stimulate the economy may come up short.

The chart below shows the comparative effects of Twist vs. the more aggressive Quantitative Easing, which, according to Chairman Bernanke, was effective.  More detailed analysis of the effects of QE2 can be found here.

Back in mid-August when the Fed started hinting about Twist, the spread between 10-year Treasury bond rates and the average mortgage loan was 2.3 percentage points. The spread today: 2.3 percentage points, which means it’s not any more profitable for banks to lend out money today, as apposed to holding onto relatively risk-free Treasuries, than it was 10 months ago.

QE2, on the other hand, was even less effective. During QE2, the difference between mortgage rates and Treasuries actually dropped to 1.7 percentage points, from 2.2, making lending less profitable. But did the drop in the lending spreads indicate that banks were willing to make loans, even at lower profits?

The Verdict on QE2

QE2 was a bit disappointing, many of the other forces negatively impacted the economy and so the small but positive effects of QE2 were swamped by the other things going on such as supply-side shockscontractionary fiscal policies, the US Treasury’s program of large scale asset sales (i.e. bond sales to finance the deficit) that directly undid much of the effect of QE2 on interest rates (more on that here.), as well as a discouraging lack of private demand. In other words, while QE2 was probably a good idea, it was not a sufficiently powerful tool to  single-handedly ensure a good recovery in the face of all of these other factors.  Many economists believe that the only policy tool powerful enough to really help the US economy right now would be a new round of expansionary fiscal policy, which is politically unlikely.

QE3 remains an alternative. Still, rather than expect a dramatic impact, the prevailing idea is that right now the US could use every little bit of help it could get.  Every month that goes by with current levels of unemployment causes permanent long-term damage to countless individual lives, as well as to the US economy as a whole.

Contrarian Offers a Refreshingly Honest Perspective

By now, we’ve heard the old argument that the Fed’s efforts to hold interest rates at artificially low levels will bankrupt us. The arguments go like this: 1. encouraging borrowing to stimulate the economy sacrificing future consumption because, as the debt is paid back, monthly consumption will decrease, while inflation will suppress the value of real wages; 2. artificially created demand will only create a new temporary housing bubble; 3. debt must be paid back with interest, which will hurt the economy.  Of course, these old saws ignore the fact that austerity measures are inherently limited without additional inflows. The only sound way to get an economy – or a business – moving is to grow your way to profitability, not just cut back expenses.

Mr. Farr’s contrarian views do not indulge the fallacious arguments that we need to slash and not invest. In fact, he seems to understands the need for the government stimulus. He just thinks that fiscal policy is not going to do the trick.

8 Contrarian Reasons to Resist Stimulus

The Fed’s purpose is to to support a recovery in housing prices by bringing mortgage rates down, and Mr. Farr has little doubt  that a new round of asset purchases Quantitative Easing (QE3) is “just around the corner.” However, Mr. Farr opposes this for these 8 contrarian reasons:

  1. The suppression of interest rates is punitive for savers. Consumers who are dependent on investment income have seen their spending power cut dramatically as a result of the Fed’s actions, and the aggregate reduction in spending power is a drag on the economy.
  2. The Fed’s aggressive purchase of long-term bonds, while keeping the Fed Funds rate at zero,  flattens the yield curve, which is bad for bank profitability. If banks are less profitable, they are less willing to expand the extension of credit – defeating a major goal of Fed policy.
  3. An incremental decrease in interest rates does not appear to improve the supply of or demand for loans. Supply is being affected by unprecedented regulatory uncertainty at the banks (in addition to the flat yield curve and economic uncertainty), and, until ambiguity about capital requirements and other issues is cleared up, the flow of credit is unlikely to improve. Demand side is affected as consumers remain over-indebted and must deleverage to repair their balance sheets, and businesses are paralyzed by uncertainty ranging from the situation in Europe to future taxes and healthcare costs.
  4. The Fed’s initiatives to bring down interest rates do nothing to remedy the problem of tight lending standards for many borrowers. As yesterday’s Wall Street Journal article byJon Hilsenrath discussed that only those who don’t need credit are able to obtain credit, while those in need who are more willing to spend or invest are unable to find banks willing to lend.
  5. The Fed’s actions may inhibit a recovery in housing as lower prices may have allowed the market to clear by now, but, instead, huge numbers of properties remain in some stage of the foreclosure process – an overhang that will drag out the process.
  6. The printing ofdollars by the Federal Reserve will create the risk of widespread inflation down the road some time. Have the Fed’s policies created a bubble in the stock and/or bond markets?
  7. The reduction in long-term interest rates is negatively affecting the funded status of pension plans, both at the corporate and government levels. As interest rates fall, companies and governments are required to set aside more money to fund these plans. This money could be put to better use elsewhere (hiring and other investments).
  8. Aggressive monetary policy may have the effect of reducing the sense of urgency felt by politicians on the issues of the fiscal cliff and long-term structural deficits.

What Farr is really saying is that the Fed has become somewhat impotent and should pass the buck to Congress, “if only Congress would answer the phone…”

What do you think?


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