|Refreshing US economy with operation twist|
|Abdullah A Dewan|
|সোমবার, ০২ জুলাই ২০১২|
To say that the US economy is growing at a slow pace is an understatement. Last month’s unemployment rate (u-rate) was 8.2% and last quarter’s GDP growth was 1.94% — both missing the projected values of 7.8% and 2.4% respectively. Meanwhile, the Fed has sharply downcast its outlook and does not expect the u-rate to fall much further this year.
Inflation remaining subdued below 2% is only one piece of good news, if you will. At its highest, the Fed expects inflation to rise 1.7% this year — below its 2% target. The Fed still expects the economy growing moderately this year but then to pick up ‘very gradually.’ Growth has averaged 2% the last four quarters.
The question now: What can the Fed do to improve the economy’s outlook? The traditional policy instruments of the Federal Reserve (primarily, open market operations and banks’ borrowing of short-term reserves from the Fed) have played their part to keep the interest rates as low as they are today.
Soon after the outbreak of the Great Recession in 2007 the Fed used Quantitative Easing (QE): QE-1 and QE-2 to lower long-term interest rates (QE-1: 2008 — March 2010 spent $1.7 trillion and QE-2: spent $600 billion that began in November 2010).
‘Quantitative’ targets a specific quantity of money to be created; ‘easing’ refers to lessening pressure on banks’ reserves. Execution of QE proceeds in two steps: (a) the Central Bank (CB) first credits its own balance sheet with money it creates ex nihilo; (b) it then purchases Treasuries (and other assets) from banks. The operation increases bank reserves — allowing expansion of loans and the money — hoping to stimulate the economy.
The QE approach is essentially the same as the traditional open market operation (OMO) of buying Treasuries to expand money and credit through increasing bank reserves. The technical difference is that the traditional OMO targets to hit and maintain a particular interest rate by altering the money supply, while QE targets a particular quantity of money to lower long-term interest rate — and then some — without having any specific long-term interest rate target.
The QE activism by the Fed was invoked because the traditional policy tools did not bring down the long-term rates low enough to boost the rundown housing sector. The overnight “benchmark” interbank interest rate (overnight interbank borrowing rate — called the federal funds rate: RFF) is already close to zero (0.0 – 0.25 % since December 16, 2008) while the economy’s outlook has not been brightened enough to lower the unemployment rate below 8 per cent. The Fed decided to do something to rejuvenate the economy. So, on June 20, the Fed Chairman Ben Bernanke announced the expansion of the $400 billion Operation Twist of September 21, 2011 by an additional $267 billion until the end of this year.
Operation Twist (OT) — named for the Twist dance craze of the time — was first used in 1961. The intent was to flatten the yield curve — one that depicts the relationship between interest yield on bonds vs. their maturities — to help promote capital inflows and strengthen the dollar.
Generally, the yield curve is upward sloping — showing, the longer the maturity of a bond (redemption date) the higher the interest yield. To perform the ‘twist’ the Fed sells some of its short-term Treasuries ( three years or less to maturity) and then uses the proceeds to buy longer term Treasuries — hence the name Operation Twist.
Adoption of OT is essentially a milder attempt to do what QE tries to do — lowering long-term rates though purchasing long-term Treasuries. While both QE and OT are open market bond purchase operations, they are starkly different in that unlike QE, which involves purchases of long-term bonds to bring down long-term rates by printing new money, OT does not (as explained above) require printing any new money — therefore avoiding the inflationary pressure associated with QE. Under the OT approach the balance sheet of the Fed remains unchanged while changing only the composition of short-term and long-term bond holdings.
There is some risk of capital outflow with flatter yield curve; it lessens the availability of long-term capital and may encourage investors to relocate funds into short-term activities to maximise gains. It is also likely to fuel the hyperbolic rise of gold price. On the other hand, businesses may continue building idle cash holdings.
Since the Great Recession the economy has been entrenched in a negative loop: consumers — trapped in a deleveraging cycle — have been showing low demand for credit, while banks with billions stuck in toxic assets on their balance sheets have been unenthusiastic to lend. This negative loop is clearly revealed in recent data. For example “Commercial loans have fallen 17.1% or $594 billion from Q4 2008 to Q2 2011, while commercial loans have slid 7.1% or $255 billion. Holdings of cash (up 19.7%) and Treasury Securities (up by 391.8%) have increased by $344 billion (30.3%).
Many analysts are questioning the OT policy as being a do little activist stance. In fact, given the current low and stable inflation environment the Fed could have executed a more aggressive activist policy of QE-3. With the OT approach, the Fed is not pumping any new money into the economy. Not too many economy watchers are excited about it because no one can really disect how much the first nine months of OT operations have revitalised the economy — if at all.
For example, long-term rates have eased down since September 2011 (when the OT was introduced) to 3.7% from 4.1% on the average 30-year mortgage. Was it all due to OT? The weakening global economic outlook and the ongoing Europe’s financial turmoil may have also contributed to this interest rate decline as investors looking for a safer shelter of their money shifted to US. Treasuries thus bidding down long-term rates here.
Even if the Fed’s OT has pushed down long-term rates by, say, a quarter of a percentage point, it’s hard to assess how much good that has done. It certainly has not resuscitated the housing sector from its comatose by any appreciable measure. Refinancing mortgage is not a problem for people with jobs and good credit history. What is needed is job creation so that the unemployed have income to buy millions of foreclosed houses or build new ones. Even though foreclosed houses are existing properties, their sales still will generate economic activity — improving banks’ cash flows, employing people to process new mortgage applications, and real estate agents to broker house purchase and sales. .
The addition of $267 billion to the OT programme may not be big enough to lower the long-term rates further? Scott Colbert, head of fixed income investing at Commerce Trust Co. in Clayton, says the 10-year Treasury yield, currently at 1.6%, could fall to 1.25% or even flirt with 1.0% this year — but only if the crisis in Europe gets worse.
The market was expecting a more aggressive Fed action —such as QE-3. However, available data could not persuade the Fed that the economy is in any imminent risk of reverting back to a double dip recession. Besides, the Fed may have decided to keep the option of QE-3 as its last policy resort in the event, the economy shows alarming signs of sliding into dismays.
The writer, formerly a Physicist and Nuclear Engineer, is a senior fellow at the Policy Research Institute, Dhaka and Professor of Economics at Eastern Michigan University, USA.
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