kevin carmichael

WASHINGTON— From Monday's Globe and Mail

Monetary policy is rarely this much fun.

For the past few weeks, economists have been debating the Federal Reserve’s next move to the sounds of the ‘60s, specifically Chubby Checker’s Let’s Twist Again.

Wall Street is grooving again to Chubby because investors and traders are gearing up for the remake of “Operation Twist,” a trick of financial market manipulation orchestrated by John F. Kennedy’s Treasury Department and the Fed in early 1961.

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The trick was to use the government’s financial clout to alter – or, if you prefer, twist – the normal trajectory of debt prices.

Typically, longer-dated debt securities pay bigger yields to compensate for the extra risk that comes from agreeing to forgo full repayment for, say, five years rather than three months. A narrowing of the gap between what it costs to borrow for several months versus what it costs to borrow for several years creates an incentive for companies to invest and hire sooner than they otherwise might.

The U.S. economy would benefit from such a spark.

Hiring is weaker than it was on the eve of the 2008 recession. The University of Michigan consumer confidence index sits at 55.7 compared with the long-run average of 86. Another report last week showed U.S. retails sales were unchanged last month. Factory production in the region around Philadelphia declined for a second consecutive month in August.

With this as the backdrop for a two-day meeting of the Fed’s policy committee this week, many are convinced that chairman Ben Bernanke and his colleagues will be doing the twist when their deliberations end mid-afternoon on Wednesday.

Analysts are less certain about the impact such a move would have on interest rates and sentiment. But that’s probably a moot point. The U.S. unemployment rate is 9.1 per cent, well in excess of the Fed’s preferred level of around 5.5 per cent. Anything that could give the economy a push without causing too much collateral damage almost certainly will be tried.

“The Fed is unlikely to sit idly by while the economic situation deteriorates,” the Royal Bank of Canada’s New York-based U.S. economists advised clients in a report last week.

In early 1961, as now, policy makers found themselves in a jam.

The economy was faltering, even though the Fed had dropped its benchmark interest rate as low as it could. But the Treasury had an idea. It thought it could use that simplest of economic principles – supply and demand – to reduce longer term borrowing rates. It would sell more debt with shorter maturities, while the Fed bought securities that matured in five years or later. They believed this would allow them to “twist” the yield curve and create an incentive for companies to invest.

Typically, the yields investors earn on debt increase in proportion to the length of time they’ve agreed to lend money. On a chart, this creates an upward slope, what economists and traders call the curve.

According to research by Merrill Lynch, the Kennedy administration and the Federal Reserve of William McChesney Martin spent $8.8-billion (U.S.) – an amount equivalent to almost 5 per cent of the total U.S. debt market – to flatten the yield curve.

Did it work? The cost of borrowing for three months rose by about 15 basis points, while the yield on 10-year notes decreased by roughly the same amount. In 2004, a former Fed governor named Ben Bernanke and some Fed staffers concluded that Operation Twist was “widely viewed as failure.” However, more recently, a re-examination by a San Francisco Fed economist suggests the current Fed chairman should have another look.

This can be said without debate: the U.S. economy escaped recession at about the same time the Fed and the Treasury implemented Operation Twist, according to the National Bureau of Economic Research, which dates U.S. business cycles.

The parallels between 1961 and now are imperfect.

Back then, officials had limited room to manoeuvre because the U.S. was obligated to keep short-term interest rates from falling too low under the terms of the Bretton Woods agreement on fixed exchange rates, which collapsed a decade later. Today, the Fed’s room to manoeuvre is limited because it dropped its benchmark interest rate to almost zero in December, 2008, and hasn’t raised it since. Also, the market for Treasuries is a much larger beast than it was 50 years ago. To match the 1961 operation, Mr. Bernanke’s Fed would have to purchase assets worth about $420-billion, according to the Merrill Lynch analysis.

Yet the principles behind the original twist manoeuvre still apply. The Fed holds about $140-billion of securities that mature over the next year. Its holdings of assets that mature in less than two years are worth almost $300-billion. If the Fed sold those holdings and reinvested the proceeds in debt with durations of 10 years or more, it would create almost as much demand for 10-year Treasuries as it did with its $600-billion quantitative easing program, which ended in June. (An important difference is the Fed wouldn’t be creating money, as it did with QE, avoiding further attacks from the vocal group of economists and politicians that believes generating new money only fuels rapid inflation.) Twisting doesn’t come without risks. Banks count on a steep yield curve to make money. They borrow short, lend long and collect profits on the difference. So a flatter yield curve could crimp profits and make banks reluctant to lend.

But that’s probably a risk the Fed is willing to take. Until the unemployment rate begins to fall, Mr. Bernanke’s stance is more likely to mirror a popular song at the moment by David Gueta and Akon: “Crank it Up.”