Operation Twist

The Federal Reserve Open Market Committee(FOMC) concluded its 2 day meeting today and here are the key takeaways from the announcement

• The FOMC now believes there are significant downside risks to the economy. The word “significant” was a change from the last meeting announcement in August.
• The FOMC decided to keep the size of its balance sheet the same but it will commence with a new operation which is commonly referred to as Operation Twist. Operation Twist involves selling shorter term Treasury debt from its inventory and buying an equivalent value of longer term Treasury debt. The Fed announced that they will sell $400 Billion of Treasury debt maturing earlier than 3 years and replace it with Treasury bonds maturing between 6 to 30 years. The goal of this operation is to reduce long term interest rates. Typically the fed sets monetary policy  by controlling very short term interest rates. Since short term rates are already zero the only other possible form of stimulus is to start pushing down longer term interest rates.
• The Fed holds a very large amount of mortgage backed securities and earlier it was rolling over the prepayments and interest payments on those holdings into treasury debt. Today they announced that they will now re-invest these proceeds into mortgage backed securities itself. This is an indication that the fed is starting to worry about a further drop in the housing market and it is taking this action to support the mortgage market

I am personally not a fan of operation twist. I think it carries more risk than reward. Here are my reasons why I think the risks outweigh the reward.

• Longer term interest rates are already very low, so any further drop is not going to be much of  a stimulus.
• Credit standards have gone up and many homeowners are under water on their homes. So some part of the population who could really use this help will not be able to refinance and benefit. Here fiscal policy could play a bigger role. There could be a program where people who are current on their mortgages but under water are allowed to refinance. The Obama administration has been considering something like this.
• Now here is the risk side. The biggest risk that comes from Fed policy is that it will cause higher inflation down the road and maybe the fed won’t be able to control it when it occurs. Currently the Fed has pushed a lot of liquidity into the economy. The way it adds liquidity is that it buys high quality assets like treasury bonds in the market and gives the seller cash(the sellers are mostly the big wall street bond dealers). Typically this cash flows through the banking system and generates credit which increases economic growth. If inflation picks up the fed performs the reverse operation by selling the assets it had acquired and mopping up the cash in order to reduce inflation. Now if it so happens that the assets the fed had bought drop in value then the fed will only be able to get back cash which is equivalent to the lower value of the assets. This is the risk the fed runs with going into longer dated treasuries. Longer term bonds carry a lot of interest rate risk. Interest rate risk means the value of the bond fluctuates with interest rates, higher rates means drop in value and vice-versa. All things being equal the longer the maturity term the greater is the interest rate risk. So in case inflation picks up and long term interest rates start rising dramatically the value of these longer dated bonds will drop quite a bit and the fed will only be able to get back cash equal to the lower value of these bonds. The fed could wait till maturity but if the maturity date is 10 years out, you don’t have that luxury to wait that long and risk runaway inflation. Lets do a very simple example, say the Fed bought a 15 year bond for $100. It buys the bond and creates $100 in cash in the sellers account. Lets say in 2 years inflation picks up and interest rates rise and the value of the bond drops to say $60. The fed can then sell it back in the market only for $60 and is unable to mop up the remaining $40 that it created. With already a large holding of Mortgage backed securities and now with operation twist the fed is adding more interest rate risk on its balance sheet. Chances of inflation rising much in the next few years is low but this is still a serious potential problem the fed could find itself in.