Ohhh Twist Again
By Robin Harding in Washington
The September meeting of the US Federal Reserve’s rate-setting committee is likely to see it take action with Ben Bernanke, chairman, signalling that it “will certainly do all that it can” to boost a struggling economy. But there is no simple choice about what to do.
The Federal Open Market Committee, which meets Sept 20-21, has to stitch together deep uncertainty about the growth outlook, a complicated set of monetary policy tools and extremely diverse views among its members over both of them. Several different tools will be up for debate.
The most likely outcome is a move to extend the duration of the Fed’s balance sheet. Such a move is nicknamed ‘Operation Twist’, because the Fed would buy more long-term Treasuries and possibly sell short-term as well, thereby twisting the shape of the yield curve.
A twist fits closely with the logic of the Fed’s last round of asset purchases – it reduces the supply of risk-free, long-term securities to investors – and the FOMC can draw on months if not years of planning. There would be plenty of opposition, but the Fed has already thrashed out many of the theoretical issues in its previous debates.
As with last autumn’s ‘QE2’ round of asset purchases, the Fed would need to set out the amount of long-term Treasuries it wishes to buy, how fast it wants to buy them and exactly which maturity of Treasury it wants.
The purchase speed would have to be somewhat slower than the roughly $100bn a month during QE2, because the Fed would be buying from only part of the Treasury yield curve, and long-term Treasuries are less liquid.
Given that such a twist is meant to work by reducing the pool of assets, rather than targeting any particular interest rate, purchases would probably be spread out among maturities. The scale would most likely depend on the degree of the FOMC’s uncertainty about the outlook – and hence for how long it wants to commit itself.
A second policy option – whether the Fed should change its language about the future path of interest rates – illustrates why this is not a simple debate about whether to ease further.
It was only last month that the Fed unexpectedly said it expects to keep rates exceptionally low until mid-2013 – but that move satisfied almost nobody on the FOMC.
On the dovish side, Charles Evans, president of the Chicago Fed, suggests a pledge to keep rates low until the unemployment rate falls from 9.1 per cent to 7.5 per cent, as long as medium-term inflation remains below 3 per cent.
There are still very few on the committee ready to contemplate any endorsement of inflation above 2 per cent, but many hawkish FOMC members are just as keen to tie low interest rates to the state of the economy, rather than a fixed date on the calendar.
“I’ve argued a lot for systematic policy, that the conditions ought to be on the economy and not on the calendar. I’ve argued that for many, many years,” says Charles Plosser, president of the Philadelphia Fed, who is often labelled as a hawk.
Mr Plosser says that he has some sympathy for the kind of policy proposed by Mr Evans, if not his numbers, but that, “to pull this kind of trigger strategy out with two numbers – it’s way too quick for us to leap to something like that. There needs to be a lot more work.”
That leaves one more issue: whether to cut the 25 basis points of interest that the Fed pays to banks on their excess reserves.
There is little enthusiasm for cutting the rate, known as Interest on Excess Reserves, as a way to stimulate the economy, so it is unlikely as a standalone move. However, there is a case for a cut now that the Fed’s mid-2013 pledge has driven Treasury rates below 25 basis points as far out as two years.
It is perverse to pay banks more on reserves than they can earn from other short-term assets: it is both a Fed subsidy to bank profits and a disincentive for banks to lend elsewhere. On the other hand, money markets already have some functional problems because rates are so low, and interest on reserves is a secondary issue.