As most econo-geeks know by now, the Federal Reserve is monetizing treasuries in an effort to lower interest rates, which in theory should encourage people to borrow and spend.
“The Fed’s monetization of government borrowing is in economic terms a hugely powerful liquidity tool,” said Lena Komileva, head of Group of Seven market economics in London at Tullett Prebon Plc, the world’s second-largest interdealer broker. “It also helps to address investor fears, by depressing government yields and private sector borrowing costs and signaling a firm commitment by the Fed to keep monetary liquidity flowing for a long time.”
The problem is that Treasury yields actually increased last week, despite massive purchases by the Fed.
So what's going on? Why are things not working as they should?
To get an answer to this we need to go back in history 48 years when something similar to this was tried before.
When the Kennedy Administration entered office in early 1961 the country faced two economic problems: a recession, and a balance of payments issue. Normally the fixes for these two issues required opposite solutions - an expansionary monetary policy in order to get the economy moving, and a contractionary policy in order to reduce demand for imports.
The Federal Reserve decided to attack both problems at the same time.
It was called Operation Twist.
The idea was for the Fed to buy Treasury bonds at the long end of the curve (more than 5 year), while selling them at the short end of the curve (less than 5 years).
Since home mortgages were hedged with long-dated treasuries, this would supposedly help lower consumer interest rates by increasing demand.
On the short end of the curve interest rates would be artificially raised, which in theory should increase foreign demand.
The policy began in February 1961 and lasted until 1965, although it was gradually phased out more each year.
In all the Fed bought about $9 Billion in Treasury debt with this program.
So did the policy work? Paul Volcker had an opinion about that in 2002.
"Well, to the extent that Operation Twist worked at all – and I must confess I was a little skeptical about it, given the fluidity of the markets even then – it too depended on some degree of market imperfection. And I think it became apparent fairly quickly that the market imperfection was not as great as had been assumed."
That sounds like "no" to me.
While the curve did indeed flatten during the 1961 to 1965 period, changes in regulations were overwhelmingly responsible for those modest differences.
Or to put it another way:
"long-term interest rates cannot be substantially reduced by money market gimmicks. “A lasting decline will be achieved only if people gain confidence in the long-term purchasing power of the dollar."
- Benjamin H. Beckhart
With this historical example in mind, can we really expect anything different this time? Or are we just kidding ourselves again?