The Federal Reserve’s Federal Open Market Committee has kept short-term interest rates near zero since late 2008 and has pledged to continue to do so until 2013. But business and household borrowers do not pay the short-term “interbank” rate. Most home loans, for example, are typically paid over the course of 15 or 30 years. Business loans - for new plants and equipment - also typically have longer-term payback periods, often coinciding with asset depreciation schedules.
By focusing on longer-term interest rates, the Fed is hoping to boost the kind of private-sector borrowing that produces jobs, especially, perhaps, in the languishing housing market.
The Federal Open Market Committee calls this new approach the Maturity Extension Program and Reinvestment Policy. It is more popularly known as “Operation Twist,” after a similar program attempted during the Kennedy administration in 1961.
Both programs were designed to change the slope of the “yield curve,” which is created by plotting the maturity dates of Treasury securities - that is, government bonds - against the interest rate each pays.
A normal yield curve slopes upward since it usually takes higher interest rates to induce investors to tie up their funds for longer periods of time. By selling short-term securities and buying longer-term government bonds, the Fed raises shorter-term rates and lowers longer-term rates. This has the effect of rotating or “twisting” the yield curve, hence the name.
The new plan calls for the Fed to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasurys. The program is expected to extend the average maturity of Treasury securities currently held by the Fed from about 75 months, or slightly more than six years, to 100 months, more than eight years, by the end of 2012.
To assess the likely success of the new program, we examined 1961’s Operation Twist.
One of the first analyses of that program appeared in 1966 in the American Economic Review, the most prestigious journal in our field. The article, by Nobel Prize winner Franco Modigliani, a well-known Keynesian, and Richard Sutch, declared the program a flop.
A February study by Eric T. Swanson of the Federal Reserve Bank of San Francisco compares the 1961 Operation Twist to the Fed’s recent second round of quantitative easing. Mr. Swanson found that the first twist resulted in a change of about 15 basis points in long-term rates, consistent with the Modigliani and Sutch findings. In plain English, that means that long-term interest rates declined by about 0.15 percentage points.
The question is: Will a minuscule reduction of long-term rates such as that actually draw consumers and firms in from the sidelines to take out new loans? It didn’t do much in 1961. It probably won’t do much today.
Keep in mind that corporations already are cash-rich. According to the most recent figures from Standard & Poor’s, there is more than $1.1 trillion in cash and short-term investments on the balance sheets of the nonfinancial firms in the S&P 500. With cash in hand, these firms don’t need new financing to purchase inventory or new equipment.
If a business already has plenty of available capacity, modestly lower financing costs probably won’t be enough to convince it to expand. Businesses nationally are operating at far less than capacity, about 80 percent; there is little incentive for them to expand beyond current plans.
Similar arguments hold for the purchases of homes. With record numbers of mortgages underwater, persistently high unemployment rates, housing prices back at their 2003 levels, and record-low interest rates, it is clear that interest rates are not driving the housing market.
So what are the possible benefits of the new monetary twist?
The only benefit we can see is that it gives the appearance that Washington is doing something to help the economy. Based on the evidence, don’t expect much beyond that.
Steven R. Cunningham is director of research and education at the American Institute for Economic Research in Great Barrington, Mass.