Twisted thinking

The Fed, like many central banks, has moved on from conventional to unconventional policy tools to attempt to stimulate the flagging US economy. This was manifested yesterday by the introduction of “Operation Twist”.

Operation twist involves the Fed selling $400 billion of US treasuries with maturities of 3 years or less to buy $400 billion of US treasuries with maturities between 6 and 30 years. This action is designed to drive long-term rates down to stimulate the economy. In a conventional world, one would expect the fall in long-term interest rates to boost consumption through driving refinancing of existing mortgage debt, making consumers cash rich, therefore encouraging new household formation, and some positive housing wealth effect. In a conventional world, the application of unconventional measures would presumably work.

However, this is not a conventional world. Hence the Fed might find that Operation Twist may have some unintended consequences.

The flattening of the yield curve caused by the twist, and the pre-emptive shout from Bernanke that rates will be kept low until mid-2013, will damage the banking sector. The flat yield curve and the anchoring of short-term interest rates will reduce the positive cost of carry that banks can earn, handicapping the banking system when the current crisis has the banks at its very epicentre. Additionally, by flattening the yield curve via unconventional policy actions, the leading indicator of economic growth – The Conference Board Leading Economic index – will point to a weaker economy. This might deter business planners who have historically looked at this indicator to assess the health of the economy and cause them to reduce or defer potentially stimulative investment plans. This will act as a drag on growth, precisely what the Fed is trying to avoid.

These are not conventional times, however there is a danger that central banks cannot get away from conventional thinking (especially the ECB). It is good to see the Fed is trying. Let’s hope Bernanke’s unconventional twisting of the yield curve turns out to be a net positive policy response, and not twisted thinking.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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