Bloomberg News

Fed May Prefer Another Twist to Adding Assets

May 18, 2012

A monitor displays Ben S. Bernanke, chairman of the U.S. Federal Reserve, while a trader works near the two-year and five-year U.S. Treasury Note options pit following a Federal Reserve Federal Open Market Committee (FOMC) interest rate press conference. Photographer: Tim Boyle/Bloomberg

A monitor displays Ben S. Bernanke, chairman of the U.S. Federal Reserve, while a trader works near the two-year and five-year U.S. Treasury Note options pit following a Federal Reserve Federal Open Market Committee (FOMC) interest rate press conference. Photographer: Tim Boyle/Bloomberg

Federal Reserve policy makers may find another round of Operation Twist is preferable to an outright asset-purchase program if the economy shows further signs of weakness or risks increase.

Chairman Ben S. Bernanke on April 25 said he was prepared to take further action to aid the economy if necessary, even as he signaled that he didn’t see an immediate need to add stimulus with inflation near the Fed’s goal and unemployment falling. The minutes from the Fed’s April meeting showed several policy makers said additional action could be necessary if the recovery slips.

“If there were scope to do another twist of some type it would be prudent to consider it, especially in the scenario where things are worse and the Fed feels like it needs to move,” said Nathan Sheets, Global Head of International Economics at Citigroup Inc. in New York. Until August, Sheets was the Fed’s top international economist.

Economists such as Sheets and Credit Suisse Securities’ Dana Saporta say the Fed’s $400 billion program to extend the maturity of bonds has been just as effective as earlier programs to expand its balance sheet, known as quantitative easing. That may make another version of the maturity extension, which is dubbed Operation Twist and is set to expire in June, preferable because it doesn’t risk the same political backlash.

“From a purely economic standpoint it doesn’t matter that much” which option the Fed chooses, Sheets said. “From a public-relations standpoint it might have consequences.”

Government Debt

With Operation Twist, the Fed has sought to lower borrowing costs through purchases of longer-term government debt. Those purchases were offset by sales of shorter-term debt, keeping the total size of the Fed’s balance sheet unchanged. The sales didn’t raise short-term yields because the Fed has pledged to keep interest rates near zero at least through late 2014.

By contrast, the Fed’s two rounds of large-scale asset purchases expanded its balance sheet by a total of $2.3 trillion. The second round, amounting to $600 billion and announced in November 2010, sparked the harshest political backlash against the Fed in three decades.

Sarah Palin, the 2008 vice-presidential candidate, called the program a “dangerous experiment in printing $600 billion out of thin air” in a letter to the Wall Street Journal.

Republicans, including House Speaker John Boehner of Ohio, sent Bernanke a letter saying it risked accelerating inflation, weakening the dollar and fueling asset bubbles.

Consumer Prices

Consumer prices as measured by the personal consumption expenditures index, the gauge preferred by the Fed, rose 2.1 percent in March from a year earlier, close to the central bank’s 2 percent inflation goal.

“The Fed has already shown itself to be sensitive to political criticism by choosing to do Operation Twist,” which didn’t provoke the same type of backlash, said Saporta, U.S. economist at Credit Suisse in New York.

Stocks and bond yields have slid since the central bank’s most recent meeting on April 24-25 amid renewed fears that Europe’s debt crisis is worsening and as data pointed to economic weakness in the U.S.

American employers added 115,000 jobs in April, the fewest in six months, according to a Labor Department report released the week after the Fed meeting.

Adding to Europe’s woes, figures released today by the Bank of Spain showed that bad loans as a proportion of total lending at the nation’s banks jumped to 8.37 percent in March, the highest since August 1994.

Treasury Yields

The Standard & Poor’s 500 Index fell for a sixth straight day, declining 0.7 percent to 1,295.22 at the close of trading in New York. The index has fallen 6.9 percent since the Fed meeting. The yield on the 10-year Treasury note was 1.72 percent, near the lowest on record, compared with 1.98 percent on April 25.

One obstacle to repeating Twist: the Fed has less short- term debt to sell, and there’s less long-term debt left in the market to buy. The Fed could solve that problem by concentrating both sales and purchases in even longer maturities, Saporta said.

In the existing program, the Fed has sold securities with less than three years remaining. The central bank would have more assets to sell if it extended its sales to securities with four or even five remaining years. The central bank’s balance sheet still has $547.7 billion of Treasuries maturing in one to five years, as of May 16.

Less Effective

Antulio Bomfim, a former Fed economist, said any new version of Operation Twist would be less effective.

“They would have to sell assets of longer maturities than they are selling now, which would diminish the effect,” said Bomfim, a Washington-based senior managing director at Macroeconomic Advisers LLC.

Any new program of asset purchases will be limited by the size of available long-term securities in the market, said Drew Matus, senior U.S. economist for UBS AG in Stamford, Connecticut.

For example, the Fed owns $310.2 billion of Treasuries with more than 10 years, compared with a total market of about $1 trillion. An additional round of purchases could push Fed ownership up to 50 percent of those maturities, potentially reducing the liquidity and functioning of the market, he said.

A survey of 21 primary dealers by the Federal Reserve Bank of New York in April showed that the financial institutions that deal directly with the Fed see another round of quantitative easing as more likely than a new version of Operation Twist.

Odds of Easing

Respondents assigned a 20 percent probability that the central bank would further increase the duration of its portfolio within one year, and 25 percent probability of such action within two years. Respondents gave quantitative easing a 45 percent chance of occurring in the next two years.

A Bloomberg Global Poll of investors, analysts and traders who are Bloomberg subscribers conducted on May 8 showed that more than three in five respondents expected the Fed to take more action to aid the economy after “Operation Twist” expires in June.

About two in five respondents anticipated the Fed will adopt a similar strategy to Twist. About one in five said it will embark on a third round of large-scale asset purchases.

Policy makers have said allowing Operation Twist to lapse wouldn’t amount to less accommodative monetary conditions.

“There should be relatively minimal effects on interest rates” when the program ends, Bernanke said in his April 25 press conference.

“Of course, we’ll continue to monitor the situation,” he said. “And if we believe that financial conditions for whatever reason are inconsistent with our macroeconomic objectives, then we will act to fix that.”

To contact the reporter on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net


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