No, the Fed isn’t powerless: Let’s do the twist

By Amer Bisat
August 22, 2011

By Amer Bisat
All opinions expressed are his own.

In recent weeks, financial markets have behaved as if the global economy is a plane crashing with no parachute in sight.  The price action is not entirely irrational.  Global growth has indeed fallen sharply and suddenly.  At the same time, the ability of policy makers to engage in bold counter-cyclical measures is being severely constrained by budgetary and political realities.

That said, the assumption that economic policy in the developed world is utterly impotent is an exaggeration.  Monetary policy in the U.S. is a good case in point. The Fed’s tool box is far from empty.  Given the persistent economic weakness and the severe headwinds facing the U.S. over the next few years, it is time for the Fed to become (even) more aggressive.

The notion that the Fed “can do nothing” is fast becoming conventional wisdom.  To an extent, it is naïve to completely dismiss the view.  Monetary policy effectiveness and the Fed’s political room-for-maneuver are arguably both at a historic low. For one thing, even though the Fed has already lowered interest rates to zero (and tripled its balance sheet), U.S. growth is frustratingly tepid.  Politically, the attacks on the Fed no longer emanate from the fringe but now represent the view of important segments of the political and academic mainstream.  The pressure, in fact, has contaminated intra-FOMC dynamics with a rarely seen concentration of dissenting voices within the Committee complicating the Fed’s traditionally consensus-based decision making process.

Monetary policy transmission has radically changed since the crisis.  The traditional mechanism—in which lower interest rates lead to increased borrowing and, consequently, higher private sector demand—is hamstrung by an over-leveraged household sector and a still-dysfunctional credit market.

Instead, in its post-modern incarnation, monetary policy is transmitted through a “portfolio rebalancing” mechanism. In particular, the Fed’s “Large Scale Asset Purchases” (popularly known as quantitative easing or QE) reduces the market supply of securities thus raising their values.  If, as the case has been, the Fed buys risk-free assets (U.S. Treasuries), then riskier assets (equities, credit, etc.) become relatively more attractive in the market place.  As investors rebalance their portfolios towards riskier assets, markets rally with a positive feedback towards aggregate demand.

Admittedly, the above “transmission mechanism” has so far had limited success.  Despite two waves of quantitative easing, aggregate demand remains frustratingly weak. However, that argument fails to consider the counter-factual: wouldn’t the economy be in an even worse shape had we not had quantitative easing?  Also, the recent economic weakness is, at least in part, due to exogenous one-off factors (higher oil prices, Japan-disaster disruptions, European fiscal woes, and the build-up of undesired inventory) some of which are already reversing. Finally, by its logic, further monetary policy easing requires a new wave of asset purchases—a prospect that is politically contentious in today’s world where policy activism has become taboo and where an aggressive Fed renders itself vulnerable to debilitating political intervention and a dangerous loss of independence.

Thankfully, though, the Fed’s tool box is not void of instruments that can achieve the same desired effect as traditional quantitative easing but are politically more palatable.  In particular, the Fed can alter the composition of its balance sheet without changing its size.  It can do so by extending the maturity of its balance sheet thus “twisting” the yield curve flatter.

To understand this policy instrument, it’s worth reviewing the basic bond concept of “duration” which refers to the degree of the inverse relationship between a bond’s yield and its price.  For example, a 1% fall in the yield of a one-year duration bond causes its price to rise by 1%.  By contrast, the same 1% fall in the yield of an eight-year duration bond causes its price to rally by a more meaningful 8%.  By definition, longer duration paper has more “octane” than shorter duration paper.

Imagine that the Fed replaces each bond it bought under the previous two QEs with a bond of the same size but with twice the original duration.  The overall size of the Fed’s balance sheet stays unchanged but the operation leaves private investors with more short-term and fewer long-term securities than they used to have before.  To rebalance those portfolios, the investors scramble for longer duration paper whose price sensitivity, for the same yield change, is much higher.  The subsequent rally has more “octane.” The Fed would achieve the same desired effect as traditional QE without having to engage in a further expansion of its balance sheet.

Clearly, the mechanics of the balance sheet compositional change are by no means straightforward.  A wholesale secondary market replacement of shorter-bonds with longer ones is operationally and politically cumbersome and, if not handled correctly, could lead to disruptive market dislocations.  The more likely approach is for the Fed to re-invest coupons and amortizations of existing bonds with longer duration bonds.

But, aside from how “twisting” operates, the simple—but crucial—point to make here is that the Fed’s sleeves are not void of tricks.  The fact that the Fed has a politically acceptable but still effective monetary policy tool should remove any excuse for lack of action. Faced with a horrendously high unemployment rate, an economy that is growing dramatically below its potential, and a persistent threat of private sector deleveraging and fiscal retrenchment, the Fed has an obligation to be more active.

The good news is that for the past five years, the Bernanke Fed has been heroically activist and forward looking. In fact, the “twisting” operation may have already started. The Fed’s recent commitment to keeping the policy rate at near zero for two more years seeks a positive duration impact very similar to the twisting process described above. Nonetheless, given cyclical and structural vulnerabilities facing the US, an even more explicit pursuit of twisting—and, dare I hope, an outright QE3—is needed.  Bernanke’s Jackson Hole speech, scheduled for August 26, can’t come any sooner.

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I don’t think that European fiscal woes should be listed among “exogenous one-off factors”. The waters from the Japanese tsunami receded but European fiscal woes are still building to what is likely to be a devastating climax.

Sarkozy is on his way to China to ask for help, but there is little China really can do. The Eurozone problems are too massive and too intractable and the Chinese are smart enough to avoid becoming entangled. The Chinese might take pity and agree to some small scale action and agree to portraying it as a larger action, but that would buy such little time that it there is really little reason to do so.

Because the European crisis is so near a climax, Bernanke would be wise to only offer soothing verbal reassurances with his Friday speech. QE 3 and “twisting” should be held at bay until after the European crisis bursts. Now is a great time to begin carefully constructing a large scale “twist”.

It would be foolish for the Fed to use up all of their magic right before they really need it.

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