The Failure of “Operation Twist”
We are in uncharted waters. The Great Recession has changed the rules for U.S. Federal government debt.
How it has changed them and what it all means remains to be seen. Tantalizing clues are found in an innocent sounding U.S. Treasury database titled, “Historical Treasury Rates“.
As scary as this sounds, it reveals that The Fed takes pot shots in the dark with monetary policy, sometimes with ineffective and even damaging effect.
Tampering with a $16.7 trillion national debt is like juggling nitro glycerin. You should be afraid. You should be very afraid.
A proof comes from one Fed policy called “Operation Twist”. The following chart tells all.
Before The Great Recession
Once upon a time, shown on the far left, U.S. Treasury yields were a happy 4.5-5% for both 10-year nominal and 2-year nominal bonds. The difference between the two was nil.
That was around the historical average for Treasury security yields. The economy was growing. People were happy. All was right in the world.
Selling U.S. Treasuries is how the federal government finances its debt.
The Great Recession
In 2007/2008, the bottom dropped out of the economy. The housing bubble didn’t just burst, it exploded like a supernova.
We were left staring off the precipice of total economic collapse and down into the maw of a 1930s style depression.
To their credit, the federal government and The Fed acted fast. It is all a big blur now with Lehman-Brothers, TARP, the Stimulus, Fannie, Freddie, Dodd-Frank, QE1, QE2, QE3 and now QE4.
Depression, though, was averted.
Significant net changes are:
- The National debt doubled from $8.3 trillion to $16.7 trillion
- The Fed has over $2.8 trillion worth of asset purchases on its balance sheet
- 10-year and 2-year bond yields have widely diverged
- 10-year Treasury yields are now only 2%
- 2-year Treasury yields are around 0.25%, practically nothing
- The Fed quickly reached the infamous “zero lower boundary” where conventional policy fails
- The Fed is now trying “unconventional monetary policy”
Note in the chart above that, as a result of the Great Recession, 10-year and 2-year nominal rates went their separate ways in 2008. They’ve remained separated by over 2% ever since.
One of The Fed’s “unconventional” policy tries is Operation Twist. It was dredged up from a 1961 Fed experiment that had dubious success. But desperate times call for desperate measures.
While reading this, keep clearly in mind that U.S. Treasury bonds are what finance federal government debt. States and municipalities purchase federal debt themselves to finance their own government’s debts. It is a tangled, incestuous relationship.
Operation Twist was started in September 2011 and lasted through the end of 2012. All told it involved $667 billion dollars worth of bond purchases.
The ultimate purpose, we are told, is to lower long-term Treasury bond yields in order to spur economic growth. Specifically, The Fed targeted a 2% inflation rate.
It works by a unique method. The Fed sells off its short-term Treasury bond holdings and uses the profits to buy long-term bonds to bring down their higher rates. Technically, it is just exchanging short-term debt for long-term debt.
Did Operation Twist Work?
In a word – No!
The above chart shows that long-term yields were already plummeting before Operation Twist even started and needed no further help staying down.
In September 2011, there was far more danger of global recession and a U.S. double-dip recession than inflation. The Fed had a knee-jerk reaction to a temporary interest fluctuation. Operation Twist was the wrong call. It was totally unnecessary.
Operation Twist would be have been harmless except for one thing… The Fed exchanged one debt interest cost for another.
The Fed exchanged a national debt interest cost for $667 billion of only 0.25% for a long-term debt interest costing taxpayers EIGHT TIMES MORE! (See chart)
We are in uncharted waters. The rules have changed. The Fed is reduced to well-intentioned monetary policy experiments that don’t even make sense and have unintended long-term consequences.
That is what happened with Operation Twist. It is probably happening right now with $85 billion/month of quantitative easing purchases.
When Treasury rates return to their pre-recession average, and they will, a national debt more than doubled in size will become a flesh-eating monster generating yearly $1 trillion interest charges.
There are two ways governments can improve their economies:
- Monetary policy
- Fiscal policy
The Fed has done all that can be done with monetary policy. The point of diminished returns has been reached.
Now it is time for the President and the Congress to act decisively with fiscal policy!