When the Kennedy Administration took office in January 1961, the United States was facing two serious challenges: an economic recession and a significant international balance-of-payment deficit. Policy makers therefore needed a solution that could simultaneously boost domestic growth and attract foreign investment in Treasuries. Given the fixed exchange rate regime at that time and the gold standard, the Fed decided to address both of these issues by purchasing long-term bonds while simultaneously selling short-term bills. The drop in long term rates from the Fed’s bond purchases helped to stimulate domestic investment, while the increase in short-term rates from bill sales helped to attract foreign investment into Treasuries. This intervention quickly became known as “Operation Twist” as the Fed’s portfolio of Treasury notes and bonds increased from 55 percent in 1960 to more than 80 percent in 1961, which, in turn, helped bring the economy out of the recession and prevent deflation.
Historians may have had a sense of déjà vu in September 2008 as the Federal Reserve again used its balance sheet as a policy tool. Operating as the “lender of last resort” (or in this case really the buyer of last resort) the Fed dramatically increased the size of its balance sheet from just under $900 billion in September 2008 to almost $2.3 trillion by early 2009 by building its mortgage portfolio to more than $1 trillion. Although this balance sheet expansion was controversial and misunderstood by a number of economists, politicians, and market participants, it helped to end the steep decline in real GDP in the second half of 2009 without sparking an offsetting rise in inflation.
In almost a mirror opposite to the challenges that Fed Chairman Paul Volcker faced thirty years ago when the Fed moved from targeting the Fed funds rate to targeting a non-borrowed reserves target as a method of controlling money supply, this Operation Twist II action represented a bold quantitative easing action to flood the system with excess reserves to battle the deflation risks of the recession as well as the massive slowdown in the velocity of money.
Prior to the August 10, 2010 FOMC meeting, the Fed’s balance sheet was anticipated to decline about $700 billion over the next 12 to 18 months, which would have represented quantitative tightening. Instead, the latest Operation Twist will keep liquidity in the banking system as the Fed substitutes maturing mortgage holdings with Treasuries. This action also puts the Fed in a more liquid position to place additional reserves into the system, if needed, or conversely to drain reserves by selling Treasuries if the economy shows more vibrancy.
The FOMC used this latest policy meeting to change its tune on the evaluation of economic conditions and the future direction of the Fed’s balance sheet. The FOMC recognized that the pace of the recovery has slowed in recent months and that the measures of underlying inflation have trended lower. This suggests that the Fed’s central tendency forecast for 3.2 percent to 4.5 percent real GDP growth for the better part of the next two years is probably in the process of being lowered.
Although monetary policy was not officially changed at this meeting the Fed’s announcement provides them with an “insurance policy” cushion to protect against the downside risks for economic activity and to combat fears on the deflation front. Accordingly, the implementation of this action will represent the start of what we will call Operation Twist III.
Market participants may be placing too much concern about risks for a protracted period of deflation. The original Operation Twist in the early 1960s helped to end the recession and prevent deflation. Although many market participants remember the inflation events of the 1970s and 1980s, the warning flag from the 1960s policy change is what happened in the mid-1960s. The Fed kept Operation Twist for several years and by 1966 and 1967 consumer inflation reaccelerated into the low- to mid- three percent area. This, combined with the “guns and butter” challenges of the 1960s, fueled a mid- to upper- three percent annualized gain in consumer inflation between 1966 and 1971, before the OPEC I and OPEC II problems took place.
So today, additional quantitative easing or maintaining too much liquidity in the system is an inflation risk if the demand side of the equation improves sharply upward. The Fed will likely learn from the past by utilizing internal checks and balances from the Volcker era as well as tracking the growth rate of bank loans and money supply to adjust the amount of excess reserves or in this case portfolio securities that it keeps on its books. Net, this latest action should improve the prospects for slow to moderate growth in 2011 as well as temper the risks for deflation.
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