He who places his hope on thee, O Virgin all-glorious, will prosper in all he does.

Inscription on Byzantine coin during reign of Romanus III

Wednesday, June 20, 2012

Fed Extends Operation Twist

The Federal Reserve decided to extend its Operation Twist program whereby it buys longer-dated Treasuries in an attempt to lower longer-term yields. Longer-term Treasury yields are the basis for setting many longer-term interest rates, such as fixed-rate mortgages. Economists tend to think that lowering borrowing costs will spur business growth. A few economists have opined that Operation Twist is simply a confidence booster and has no real economic effect.

In my view, Operation Twist accomplishes a couple of things. First, it monetizes the Federal debt. Yep, this, along with the Quantitative Easing programs, is part of the monetization program that's been going on for a while. Now, some may disagree with me because the Fed is simultaneously selling short-term Treasuries while it's buying longer-term bonds--thereby creating a seemingly neutral situation. The problem with this view is that the Fed is already injecting liquidity to hold short-term interest rates near zero. If Operation Twist raised short-term interest rates because of T-bill sales, the Fed would fight the rise through normal Open Market Operations. Net effect? Net positive liquidity.

Is the Fed injecting too much? No one knows right now. Economic impacts work through human beings' earning their livelihoods. The lags and impacts in real-time can't be predicted with apodictic certainty, but can only be studied afterward when the economic historians take over. Ben Bernanke is confident in his ability to short-circuit future price inflation by using reverse repurchase agreements to suck the excess liquidity out of the system. So far he's done a good job as a central banker, and he may be able to pull it off. The market agrees and isn't forecasting a significant uptick in price inflation over the next ten years.

Second, the Fed is jumpstarting commercial lending. Commercial banks are scared to death to take on any sort of risk by lending to private enterprises. Banks are whipping boys right now, and the impact of Dodd Frank regulation on capital ratios and operations and payrolls has yet to be known. Small businesses are heavily dependent on bank credit since the credit markets (and their high costs) favor larger players. The Fed is trying to inject loanable funds into the economy, but the Fed is operating through the capital markets and therefore benefiting larger companies, rather than the smaller enterprises that fuel the lion's share of job growth during the business cycle's recovery phase. Net effect? Net job growth, but anemic job growth, since the smaller players are still stagnating.

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