A futile Fed twist

By Luis Arroyo, in Madrid | How could monetary constraints be eased without issuing money or lowering interest rates in the short term?

The Federal Reserve yesterday hosted a meeting of the FOMC, a committee whose purpose is making monetary policy decisions.

It decided –not unanimously, though– to apply what has been called “Operation Twist”, i.e., a swap of stock bonds for market bonds with long term maturity. This time, the volume is $400bn. In essence, this is bartering or an exchange move seeking to lower the long term interest rate but avoiding a net emission of money. As the communiqué says, the Fed will acquire Treasury bonds with six to 30 year-maturity in exchange for the ones that the Fed has at three-year maximum maturity. Thus, the yield curve will ‘flatten’ and so it supposedly will stimulate long-term investments.

The vote on the resolution was seven in favour vs. three against: Kocherlakota, Fisher and Plosser. These three hawks oppose any type stimulus, even this one that does not imply an increase in liquidity.

The stock market’s reaction has been negative, because it has acknowledged that the Fed is more worried about economic weakness than was previously thought. Also, it led to notice that there must be serious political constraints for the Fed to face if it really wished to do something more substantial. Interest rates at 30 years did show a positive reaction, and decreased from 3.22% to 3%.

But I’m not confident that this is going to be enough. The problem is that the cost of financing private investment is higher than ever and, as Friedman himself explained in his book about US monetary history, this is always interpreted as a bias towards safety and liquidity. If the measure does not affect the private bond, the long-term expectations of the real economy, the GDP and the investing activity, it will be meaningless.

Luis Arroyo is a former Bank of Spain economist. He writes regularly for www.consensodelmercado.com.