Monday, September 19, 2011

Go, Chubby, Go: Let's Twist Again!

With the Federal Open Market Committee (FOMC) attempting to save the U.S. economy from itself once again at a two-day meeting this week, it appears a new cover of "Operation Twist" may be atop the playlist of at least some of the committee's members.

The Federal Reserve conducted the original Operation Twist a half-century ago under circumstances Titan Alon and Eric Swanson describe well in their "Operation Twist and the Effect of Large-Scale Asset Purchases," which appeared in the FRBSF [Federal Reserve Bank of San Francisco] Economic Letter last April 25:

"John F. Kennedy was elected president in November 1960 and inaugurated on January 20, 1961. The U.S. economy had been in recession for several months, so the incoming Administration and the Federal Reserve wanted to lower interest rates to stimulate the weak economy.

"However, Europe was not in a recession at the time and European interest rates were higher than those in the United States. Under the Bretton Woods fixed exchange rate system then in effect, this interest rate differential led cross-currency arbitrageurs to convert U.S. dollars to gold and invest the proceeds in higher-yielding European assets. The result was an outflow of gold from the United States to Europe amounting to several billion dollars per year, a very large quantity that was a source of extreme concern to the Administration and the Federal Reserve.

"The Kennedy Administration’s proposed solution to this dilemma was to try to lower longer-term interest rates while keeping short-term interest rates unchanged -- an initiative now known as 'Operation Twist' in homage to the dance craze then sweeping the nation.

"The idea was that business investment and housing demand were primarily determined by longer-term interest rates, while cross-currency arbitrage was primarily determined by short-term interest rate differentials across countries. Policymakers reasoned that, if longer-term interest rates could be lowered without affecting short-term yields, the weak U.S. economy could be stimulated without worsening the outflow of gold."

Hmm. In the anticipated remake of Operation Twist, the Fed is expected to first sell shorter-term U.S. Treasury securities already on its books and then employ the proceeds to buy longer-term U.S. Treasury securities, with little or no effect on the bottom line of its overall balance sheet. Meanwhile, the cross-border flow of gold seems to be a nonissue this time around, given President Richard Nixon's closing of the gold window in 1971, which ended the convertibility between the precious metal and U.S. dollars. Hmm.

In the words of one of my favorite financial-market observers after the FOMC's announcement last Nov. 3 that it would be monetizing an additional $600 billion in U.S. debt by purchasing an assortment of U.S. Treasury securities, "I believe this plan may have a limited impact on the U.S. economy."

Because of the inviolable Risky Business Law of Unintended Consequences, however, this apparent new program could boost prices in certain financial-asset classes, such as commodities. (As I once noted elsewhere, one effect of this unbreakable law appears to be that every time I slip-'n'-slide my way into the shower of the RB Executive Washroom, the telephone rings. Given my unique blend of astigmatism and myopia, this could one day lead to a pretty humorous obituary.)

Operation Twist: Those oldies but goodies remind me of you* . . .

*Props to Little Caesar & the Romans