The Fed is expected to announce a little after 2 p.m. that it will ease monetary policy by rearranging its holdings of Treasury securities to include more long-term bonds. By raising the average maturity of the $1.65 trillion in Treasury securities it owns, the Fed hopes to lower interest rates on long-term bonds and stimulate borrowing and spending.
Fed-watchers have dubbed this procedure “Operation Twist,” after a similar step taken by the Fed during John F. Kennedy’s presidency in 1961. The idea is to make the Fed’s portfolio more stimulative without changing the overall size of its balance sheet.
Here’s a snapshot of the Fed’s current assets, provided by the Cleveland Fed:
The bottom two sections represent, roughly, the Fed’s Treasury holdings. The orange bar is traditional holdings, and the mustard is longer-term assets of the kind the Fed purchased in its QE2 program. The sharp increase in Long Term Treasury Purchases beginning in late 2010 marks QE2.
What Operation Twist will do, in effect, is decrease the size of the orange bar and increase the size of the mustard bar, which will leave the overall level of Fed assets unchanged.
What everyone wants to know, of course, is whether this will help the economy — or, alternatively, spark inflation. Based on the impact of QE2, and the limited size of a possible Operation Twist, it seems probably that it won’t have much of a measurable impact one way or another. Bloomberg suggests that the Fed will begin “selling securities with one to three years remaining maturity, and purchasing mostly those with seven to 12-year maturity.” The simple fact is that there aren’t enough bonds of one- to three-years remaining maturity among the Fed’s assets to do anything on the scale of QE2.
As an illustration of this fact, here’s a graph showing the Fed’s total Treasury holdings (blue line) relative to its holdings of Treasury securities marturing in less than five years (green line) and less than one year (red line).
Given that there’s significant overlap between the categories, it’s fairly clear that the Fed is limited in how many Treasury bonds maturing in less than three years it has to sell. And considering that Operation Twist-style swaps of short-term for long-term bonds is less stimulative than QE2-style outright purchases of long-term bonds, there’s clearly a ceiling to what the Fed can accomplish through Operation Twist. According to Bloomberg, the Fed’s goal will be to bring down yields on longer-term bonds by 0.1 percent. Whether that’s realistic or not, it wouldn’t satisfy the Fed’s dovish critics, nor should it scare inflation hawks.