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Operation twist – then and now

A number of readers have asked me to clarify what I mean when I say that the central bank can control the yield curve at all maturities. This came up again when Marshall Auerback commented that the 1961 Operation Twist exercise in the US provides a model for central bank policy options. In 1961, the US Federal Reserve attempted to flatten the yield curve to bring down long-term rates for an economy that was mired in recession, yet at the same time, push short-term rates up to deal with a balance of payments crisis. The fixed exchange rate system meant they were losing gold reserves and desired to stop that drain. It is an interesting story though as to what happened and whether it has implications for the present. As you will see, the fact is that the central bank can control the yield curve and eliminate the influence of the bond markets if it chooses. The only reason it doesn’t do this is ideological.

Let me state at the outset that based on the understandings that Modern Monetary Theory (MMT) provides the following policy option is redundant. The best thing that a sovereign government can do is consolidate its treasury and central banking operations (make them consistent in a policy sense) – which would make macroeconomic policy totally accountable to voters unlike today where the central bankers do not face election.

Then the treasury should net spend as required to ensure that the economy achieves and sustains full employment and price stability. This may under some circumstances (very strong external surpluses) require a budget surplus, but normally for most countries it will require continuous budget deficits of varying proportions of GDP as the saving desires of the private domestic sector varied over time.

The treasury should issue no debt at all. There is a weak case for the government issuing only short-term paper to allow the central bank to reach its target interest rate via liquidity management operations. But this case is made by those who argue that monetary policy should be used as a counter-stabilisation tool. I think monetary policy should be put to bed and all counter-stabilisation be performed via fiscal policy.

So in that context, there is no case for governments to issue any debt. This choice would introduce no increased inflation risk. The monetary operations that accompany fiscal policy changes have very little impact on increasing or decreasing the inflation risk of continuously running an economy close to full capacity. The risk is real but can be managed.

Further, there is no financial reason for issuing the debt because the sovereign government retains monopoly control over the currency. The practice of debt-issuance is a hang-over from the gold standard era where governments had to “finance” their spending in order to retain control over the exchange rate.

The practice has lingered because it is now a convenient ideological cum political tool used by neo-liberals to limit the size of government and to give the corporate sector access to corporate welfare (the risk-free government debt) that they use to create profit.

If everyone knew that there was no functional (financial) reason for the government to issue debt and that it just transferred public funds into the hands of the speculators then I think attitudes might change. Eventually …

Anyway, that is the preferred MMT policy option.

The reality is that that option is not taken advantage off (like some many lost opportunities available to a fiat currency-issuing government) and governments continue to issue debt and expose themselves to the bullying tactics of the bond markets. Please read my blog – Who is in charge? – for more discussion on this point.

Now back to Operation Twist. The queries for clarification of my statement that the central bank can control the yield started a while ago when I wrote this blog – Things that bothered me today – where I referred to a speech that Ben Bernanke made on November 21, 2002 to the National Economists Club in Washington on the theme – Deflation: Making Sure “It” Doesn’t Happen Here.

Bernanke was talking about what would happen in the event that a deflationary episode tests “conventional monetary policy” because of the “zero bound on the nominal interest rate”. He said:

Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate … and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.

In this context, he noted that at this point most commentators believe the “central bank has “run out of ammunition” – that is, it no longer has the power to expand aggregate demand and hence economic activity”.

He then outlined a number of other policies tools available to argue that “a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition”. He then outlined how the central bank could influence the yield curve (to stimulate aggregate demand) by:

announcing explicit ceilings for yields on longer-maturity Treasury debt … [and enforcing those] … interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.

In other words, the central bank can control the yield curve.

Operation Twist …

Anyway, Operation Twist began in the US in the early 1960s at a time that the US economy was facing a current account deficit which was putting pressure on the exchange rate and

Operation Twist started in February 1961 soon after JFK was elected to office. The US was in external deficit and recession at the time. It is also important to note that the world was operating under the Bretton Woods system of fixed exchange rates which pegged world currencies to the US dollar, which in turn, was pegged to gold. So it was a convertible currency monetary system and central banks were constrained to using monetary policy to defend their parity.

The US was facing downward pressure on its exchange rate but had to convert dollars into gold on request and so faced a gold drain at the time. Something had to be done.

The particular interventions that were the hallmark of Operation Twist – selling short-term government debt to drive down prices and drive up yields (to attract capital inflow) and buying long-term government debt to drive up prices and hence drive down yields (to encourage private investment) – have to be seen in the context of the fixed exchange rate system.

Operation Twist was abandoned in 1965.

Trying to draw conclusions about how it might work now from this exercise in the 1960s is not particularly helpful except that the mechanics of the exercise are clearly available today and the flexible exchange rate regimes make it much more effective.

Operation Twist thus aimed to “artificially flatten or twist the typically upward-sloping yield curve”. You can read the actual operations in more detail from this paper by Adam M. Zaretsky. He is somewhat negative about the policy but provides interesting background information.

What was the empirical outcome?

As Zaretsky concedes:

Regardless of this portfolio restructuring, the policy’s success should be measured by its effect on the rate structure of the yield curve … the gradual flattening in the yield curve between 1961 and 1966 might, at first glance, suggest the policy was successful.

You can access complete sets of financial data from the US Federal Reserve. It is an excellent data source. The following graph compares the yield spreads of the US Federal Funds (effective) rate (the overnight rate set by monetary policy) against the market yield on U.S. Treasury securities at 1-year, 3-years, 10-years and 20-years at constant maturity, quoted on investment basis (so the non-indexed government bond yields).

So the spreads are the percentage point difference between the various rates, which of-course define the treasury debt yield curve. You can see that even notwithstanding the relative size of Operation Twist, the spreads flattened dramatically in the period of its operation. There were clearly other factors operating that have been noted in the research literature but by itself the operation was successful.

You might be interested in the following short video I made today to demonstrate what happened to the US yield curve during the early to mid-1960s. It is very rough (done via a USB camera and audio) but should be of some interest.

So was it successful or not?

In 2004 paper written by Ben Bernanke, Vincent Reinhart, and Brian Sack – Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment – the authors examine the future of monetary policy when short-term interest rates, the principle tool of monetary policy get close to zero (as they are now).

They seek to explore whether alternative strategies would be effective when the short-term interest rate was zero. The policy alternatives are:

(1) using communications policies to shape public expectations about the future course of interest rates; (2) increasing the size of the central bank’s balance sheet; and (3) changing the composition of the central bank’s balance sheet.

So what we are talking about here are strategies to alter the composition of the central bank’s balance sheet “in order to affect the relative supplies of securities held by the public.”

The authors note that the:

Perhaps the most extreme example of a policy keyed to the composition of the central bank’s balance sheet is the announcement of a ceiling on some longer-term yield, below the rate initially prevailing in the market. Such a policy would entail an essentially unlimited commitment to purchase the targeted security at the announced price.

It is also interesting that the authors (in a footnote on page 25) say that “In carrying out such a policy, the Fed would need to coordinate with the Treasury, to ensure that Treasury debt issuance policies did not offset the Fed’s actions.” So as long as the government operates as a consolidated policy sector their actions will be self-reinforcing.

Mainstream economists have eschewed this sort of strategy and claim that the only way this could be successful would be if it ratified the market. That is, the only way the central bank could “enforce a ceiling on the yields of long-term Treasury securities” would be if the “targeted yields were broadly consistent with investor expectations about future values of the policy rate”.

However, these economists mostly use “frictionless financial market” models where there is no time or transaction costs and everyone has perfect information and equal access. Clearly that sort of model has nothing to say about the real world we live in.

But even so, the only consequence of a discrepancy between the targeted yields and the market expectations of future yields (that is, the bond traders considered rates would rise eventually) would be that the “central bank would end up owning all or most of the targeted security.” My assessment of that outcome – excellent.

The bond traders might boycott the issues and “force” the central bank to take up all the volume on offer. So what? This doesn’t negate the effectiveness of the strategy it just means that the private buyers are missing out on a risk-free asset and have to put their funds elsewhere. Their loss!

Eventually, if the government bond was the preferred asset the bond traders would learn that the central bank was committed to the strategy and would realise that if they didn’t take up the issue the bank would. End of story – the rats would come marching into town piped in by the central bank resolve.

The authors also suggest that it is possible that:

… even if large purchases of, say, a long-dated Treasury security were able to affect the yield on that security, the possibility exists that the yield on that security might become “disconnected” from the rest of the term structure and from private rates, thus reducing the economic impact of the policy.

That is possible. The corporate rates which reflect risk as well as inflationary expectations might deviate.

The overall point is that when there are transaction costs and “financial markets are incomplete in important ways”, the central bank can influence “term, risk, and liquidity premiums – and thus overall yields.”

The authors note that historically the strategy has been successful in a number of countries and give examples. Among the examples, they consider the “historical episode” that became known as “Operation Twist”.

Austrian School fanatic Mish Shedlock ran a column where he talks about Operation Twist. As an aside his blog mostly involves extensive use of press reports etc with usually acerbic one-line statements that often do not accord with the authority he uses. The ratio of borrowed content (which he references) to his own narrative is very high – closing on 100 per cent.

In his Operation Twist blog he reproduces a large section of a Reuters press release from March 2009 which carried the title Fed says let’s Twist again after 48 years. The press release suggests that the quantitative easing that the Federal Reserve has been engaged in recently was a reply of Operation Twist. But as you read further, they admit that the only similarity between now and then is that the Federal Reserve bought “longer-dated U.S. government debt”. At that time, they also sold short-term bills which “sterilized … its impact on the money supply” which is not the case with quantitative easing.

Mish though wants to associate Operation Twist with what the Federal Reserve was doing during 2008-09 which he believes (as an blinkered Austrian-schooler) would be highly inflationary. He wrote that a year ago. We are still waiting for the hyperinflation. No signs yet!

Of-course, first, there would have to be a major credit expansion and there are no signs of that. Why? Banks don’t lend reserves. Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

Anyway, Mish claims that “Inquiring minds are no doubt asking “Was Operation Twist Successful?”” and claims the answer is contained in this quotations from a speech Paul Volker made in 2002. Volker was in the US Treasury at the time of Operation Twist. The quote, which apparently, leads Mish to conclude “That sounds to me like a resounding “No” is as follows. Volker says:

Well, to the extent that Operation Twist worked at all – and I must confess I was a little skeptical about it, given the fluidity of the markets even then – it too depended on some degree of market imperfection. And I think it became apparent fairly quickly that the market imperfection was not as great as had been assumed.

But if he had have quoted the full text his readers might have had a different perspective. In fact, the financial markets were very imperfect at that time. Volker talks about the results being blurred interest ceiling imposed on commercial banks by the so-called Regulation Q.

If Mish really wanted to learn about Operation Twist rather than just offer a knee-jerk prejudicial stab in the dark he might have read the literature on the period and the main antagonists were as follows.

Modigliani, F. and Sutch, R (1966) ‘Innovations in Interest Rate Policy’, American Economic Review, 52(1/2), 178-97.

Modigliani, F. and Sutch, R (1967) ‘Debt Management and the Term Structure of Interest Rates: An Empirical Analysis of Recent Experience’, Journal of Political Economy 75(4, part 2), 569-89.

Most people who do not read that work (or do not read it carefully) have inherited the “folk lore” that Operation Twist was mildly successful at best. Modigliani and Sutch (1996: 196) showed that the long-short spread was narrowed by amounts that:

… are most unlikely to exceed some ten to twenty base points-a reduction that can be considered moderate at best.

But they qualified their finding (which is usually left out of modern discussions of the papers by the main-streamers who hate the idea of Operation Twist type strategies) and noted that the operation was “relatively small operation, and, indeed, that over a slightly longer period the maturity of outstanding government debt rose significantly, rather than falling”.

Why would that have been occurring?

Robert V. Roosa who was a Treasury under-secretary at the time gave a lecture to the Industrial College of the Armed Forces in Washington on October 31, 1963 entitled The management of the national debt. I cannot link to it because I read it off fiche in the library. He said that the US Treasury wanted to increase the issuance of government debt because it knew the central bank was willing to buy them. As the BIS Quarterly Review, June 2009 note:

At the same time, advance refundings of coupon securities approaching maturity reduced outstanding debt in the “belly” of the curve, ie in
the one- to five-year maturities. In current parlance, the Treasury was issuing in “barbell” fashion – at three months and beyond five years. It is not clear that studies that related a 10-year Treasury bond yield to a three-month bill rate took proper account of the Treasury strategy.

So nothing of the simplicity that Mish wants us to believe.

This observation was endorsed by Thomas R. Beard who was in the Federal Reserve, published an article entitled U.S. Treasury Advance Refunding in 1965. I cannot link to it because I accessed it in hard-copy from the library some years ago. In that article he wrote (page 59):

In the four years 1961-64, net purchases outside the 1-year area amounted to only $6.9 billion, of which only $2.3 billion represented over-5-year maturities. For every dollar of intermediate- and long-term bonds purchased by the System, the Treasury has sold many times that amount.

Accordingly, the BIS conclude that:

This policy experiment is often thought to have been a failure. In fact, the experiment never happened. The Treasury’s extension of maturities overwhelmed the Federal Reserve sale of bills and purchase of bonds …

The latter point was also noted by James Tobin in 1974 in his book – The New Economics: One Decade Older published by Princeton University Press. On pages 32-33, you will read that he blamed US Treasury debt management strategies which “undercut any effects that might have followed from the relatively small change in the composition of the Federal Reserve’s balance sheet” for the small outcomes.

So far from being a failure as the simplistic Mish would like us to believe, the policy was complicated by other circumstances and there was not close co-ordination between the US Treasury and the central bank.

The Federal Reserve authors conclude fairly:

Thus, Operation Twist does not seem to provide strong evidence in either direction as to the possible effects of changes in the composition of the central bank’s balance sheet.

The question is would it work now?

The Federal Reserve authors clearly think so:

If the Federal Reserve were willing to purchase an unlimited amount of a particular asset, say a Treasury security, at a fixed price, there is little doubt that it could establish that asset’s price. Presumably, this would be true even if the Federal Reserve’s commitment to purchase the long-lived asset was promised for a future date. Conceptually, it is useful to think of the Federal Reserve as providing investors in that security with a put option allowing them to sell back their holdings to the central bank at an established price. We can use our term-structure model to price that option.

After a detailed empirical study of “non-standard” monetary policy initiatives in the US and Japan, the Federal Reserve authors conclude that:

We also find some evidence that relative supplies of securities matter for yields in the United States, a necessary condition for achieving the desired effects from targeted asset purchases … the term structure analysis … [for Japan] … does suggest that longer-term yields have been lower than might have been expected in recent years …

We believe that our findings go some way to refuting the strong hypothesis that nonstandard policy actions, including quantitative easing and targeted asset purchases, cannot be successful in a modern industrial economy.


The overall point is that the notion that bond markets can hold a sovereign government to ransom is invalid. Governments allow themselves to be bullied by the bond markets. All the power is in the hands of the government should they choose to use it. And the power would be exercised through markets – not by any dictate.

The announcement by the central bank that it will control the yield curve at desired policy rates doesn’t stop the bond traders buying the risk-free annuity. They just can’t buy it on their terms which is what economic policy is all about – influencing private decision making to advance public purpose. Nothing sinister about it at all.

But while the central bank can achieve this end the desirable option is for the government to abandon issuing debt altogether.

Digression: Retail sales in Australia

Fell again last month as the impact of the fiscal stimulus has well and truly worked its way out. The hope now is that investment will pick up and the public infrastructure projects provide some stimulus. More tomorrow on this!

Finally …

My band is playing tonight so …

That is enough for today!

This Post Has 25 Comments

  1. Bernanke’s option of controlling the yield curve was a contingency based on zero bound in play.

    MMT prescribes zero bound (zero rates) in play as a matter of permanent policy.

    But presumably MMT prescribes yield curve control even without zero rates.

    In that case, MMT must allow for a bloated balance sheet to accommodate unlimited twisting – i.e. “unlimited” purchases of long treasuries funded by “unlimited” short funding in the form of excess reserves.

    That introduces the cosmetic risk of further misinterpretation of excess reserves by neoclassical misunderstanders.

    One way to get around the cosmetic risk, and “Mankiw immunize”, is for the Fed to twist via “unlimited” interest rate swaps (receive fixed; pay floating) instead of cash (buy treasuries; issue reserves).

    This has the added benefit of the likely compression of swap spreads as well, which provides additional direct interest rate easing to the banking system, beyond the lower treasury yield per se.

    The market overall will arbitrage the derivative result into the cash Treasury and bank funding markets.

    And the Fed’s balance sheet will be transferred to a long/short “gap” position via the same interest rate swaps. It’s effectively a bet that the fed funds rate trajectory will remain low.

    It’s all interest rate risk, cash or derivative.

  2. Bill,
    Crackerjack-friggin post.
    Eye on the ball.
    Very well done.
    Perseverence on a righteous course brings reward.
    From the Preponderance of the Small.

  3. Dear Bill,

    I am not sure I agree with you when you say: “The treasury should issue no debt at all.”

    Government T-bills is in a sense a more democratic instrument than excess reserves since anyone can hold T-Bills. Earning interest on excess reserves is the sole preserve of a select club called primary dealers. You can get around this problem by allowing people to make deposit at the central bank and earn interest directly from the Central Bank (thereby circumventing the private banking system), but until this option becomes reality (and I’m under no illusion), I think it is still preferable for government to issue T-Bills.

    BTW- I am a relatively new reader on your blog. Thanks for all your good work. I have been learning a lot.

  4. Really enjoyed the you-tube presentation. I hope in the future you consider embedding more videos in your blogs.

  5. JKH/Matt,

    Our discussion at NC became too “threaded”, so copying my latest comment here with a bit of modification

    Not sure if this is relevant : The eurozone and limited liability non-bank government debt March 29

    For example around 30 per cent of Greek government debt is held by commercial banks from other European countries and nearly 20 per cent is in the hands of domestic banks.

    Also, banks wouldn’t need reserves to purchase government debt. They can just make deposits for the governments in exchange for government bonds (since loans make deposits). So I don’t think that there is any issue. Banks can purchase government debt in two ways – using reserves and making deposits. Banks need not settle in reserves in the US as well – they can make deposits for the Treasury by purchasing newly issued debt. Quoting Randy from his book Modern Money

    When new government debt is auctioned, the Treasury often designates a portion of the auction as being eligible for purchase through credit by special depositories. In this case, the special depository obtains the bond as an asset by issuing a deposit in the name of the Treasury

    So the â‚Ŧ442b reserves created by the Eurosystem is hardly needed to bailout governments.

    This paper from Buiter says NCB wont bailout under any circumstances – he was a central banker so maybe he is right. How the Eurosystem’s Treatment of Collateral in its Open Market Operations Weakens Fiscal Discipline in the Eurozone (and what to do about it) (forget the “discipline” part)

    We recognise that, despite the Treaty ban on direct financing by the Eurosystem of member governments (no direct loans from the Eurosystem and no direct purchases of government debt by the Eurosystem in the primary issue market are permitted), the Eurosystem could, if it wished to do so, bail out member governments by outright purchases of their debt in the secondary markets. This would not violate the letter of the Treaties and the Protocols, but it would certainly violate their spirit. Again, there is no evidence to suggest that the ECB would, under any conceivable circumstances, knowingly choose to bail out fiscally challenged Eurozone governments through outright purchases of their debt instruments or through equivalent ways of monetising the debt of the fiscally incontinent.

    From the early days of the EMI (Lamfalussy (1997)), through the Presidency of Wim Duisenberg and now during the Presidency of Jean-Claude Trichet, all those who matter for a bail-out decision have clearly and publicly stated that a bail-out of the fiscally improvident by the Eurosystem is not an option. We take them at their word: there will be no bail-outs by the Eurosystem.

    Of course that was in 2005, but as Bill (our host, not Buiter) mentioned in a comment they wont do it now either.

    Also â‚Ŧ38b intra-euro system liabilities because of TARGET2 transfers are no cause for concern since it is an accumulated amount over many years not just one year. Plus there is no interest payment needed on those liabilities.

    Right now the level of reserves in the Eurosystem is high. In normal times, a BoP may induce an NCB to buy government bonds to bring the reserves back to the original, but now they don’t because of the high level of reserves in the system.

  6. Which brings me to another point. Matt once mentioned that there is hardly a possibility that Greece could default whatever the rating agencies say and I fully appreciate his point now. Banks have so much government debt on their books. So it is better for them to purchase more debt even if the fiscal and monetary folks don’t allow them to. They just buy government bonds and make deposits for them. According to the latest monthly bulletin, the governments hold a lot at the banks â‚Ŧ200b+

    So I were to make any prediction – I would say that there is no chance of any default. On the other hand, the bond may sell cheap and governments will cut spending while credit rating agencies will blackmail them and this will lead to a lot of pain for the innocent citizens.

  7. Bill: thanks for the usual daily informative read. Just two criticisms.

    You say “The best thing that a sovereign government can do is consolidate its treasury and central banking operations….”. Isn’t there much to be said for keeping central banks and treasuries separate in that it stops politicians having direct access to the printing press?

    Second, you say in reference to the deficit, “but normally for most countries it will require continuous budget deficits of varying proportions of GDP as the saving desires of the private domestic sector varied over time.” I suggest that “saving desires varying over time” is not the explanation for a more or less continuous deficit.

    As I pointed out two or three weeks ago, the basic reason is that given the supposedly ideal inflation rate of 2% and economic growth in real terms of X% a year, the monetary base and national debt will have to expanded by (2 + X)% a year in money terms. Assuming to keep it simple that saving desires are constant, and that national debt and monetary base are a constant proportion of GDP, the deficit would need to be ((2+X)/100) x (monetary base plus national debt) per annum (I think).

    That might be a niggling technical detail, but MMT people need to get every bit of their arguments accurate: it helps demolish opposition.

  8. Ramanan,

    Lots of permutations and combinations there – central banks, commercial banks, reserves, deposits, repos, etc. etc.

  9. Here is my compression algorithm for those that want to save themselves reading 3500 words of tap-dancing — although watching the contortions is enjoyable.

    Here is my shorter Bill:

    1. The government can control maturities at any rate, as evidenced by operation twist — here is a pretty chart! You can see it, can’t you? Can’t you? Isn’t it obvious that that isn’t random noise, or a chaotic evolution, but a powerful government effect? Squint! Let’s see the analysis

    2. Hmm, it seems that the operation failed. However, I am certain that they would have succeeded if they had had more resolve. Send more troops!

    3. Even if we do not succeed, we can always buy up all the government assets outright, and then change the definition of yield curve. In this way we will convince people that the risk free rates are not the returns provided by holding a broad basket of securities, but rather the rate provided by holding government securities that no one, in fact, holds.

    4. Moreover, I will intentionally mislead my readers and infer that because there are frictions in every market, that every market is not perfectly elastic over the long run — e.g. by ignoring time horizon and the response time of the arbitrage function, I will avoid all the important issues.

    In the real world, we can look at what happened to Agencies — the victim of two twists. In the first twist, foreign CB’s dumped treasuries in mass numbers, and in the second twist, our CB tried to lower the price by purchasing large quantities. In both cases, the relationship between Agencies and Treasuries stayed within their historical bands. Later on, even though Congress allocated funds to bail out the agencies, purchased equity in them, waived solvency requirements, and the Treasury later (illegally) announced that those funds would be unlimited, they remained in their historical bands. Something that should certainly change the risk profile (and hence price) of the security.

    The real question is why the yields are are still so much above the risk-free rate, given these supports — the market is speculating that there is a non-zero risk of agency bondholders getting a haircut, even though Bear Stearns bondholders were made whole. This means that the market has more faith in democracy than the ordinary public. Again, another potentially interesting discussion sacrificed at the expense of intellectual conformity and little red book quotations.

  10. Hi RSJ,

    As far as the agencies I cant find NYFed operating data, but for the Agency MBS if you check out this link here at the NYFed, it shows the process of how they went about purchasing MBS over the last 15 months. Everyone thinks they were just “buying”. They reported in “net purchases” type of format, which means and you can see they were both buying and selling MBS. this smacks to me of targeting a price range for the MBS, why else would you sell if you were just trying to lower mortage rates? You would just buy. To me, they didnt want mortgage rates to go below 5%, (I think this was an unfair policy btw.) I submit that if they would have just kept buying they could have easily ran mortgage rates down to 4%, and let legitmate homeowners (not speculator flippers) a much deserved opportunity to refinance at historic low rates.

    But its too late now. The program is over. SICK cnbc was running a funeral dirge as bumper music in honor of the “death” of Quantitative Easing today. Lets see what happpens now.

  11. When I read the post I was thinking exactly what Ralph is saying in regard to the maintenance of economic policy through managed deficit funding over the long term.
    The real reason for doing so is to maintain a non-inflation/deflationary amount of money in existence and so the formula he presents approximates the size of the deficit to be filled using direct government spending.
    It’s what I call money-creation by the GOVUS, which would happen to put us back to on a Constitutional monetary framework – perhaps not globally applicable.
    But when I re-read it again, what I got out of it was Bill’s identification of the deficits and government spending as that required to meet the policy goals of economic stability and full employment.
    So, knowing that would be the policy objective in play, and thus that the result would be the same amount of money creation as Ralph’s formula, my conclusion was that the explanation might be incomplete for me, but accurate to the discussion of Operation Twist.
    I happen to be one for whom the issue of monetary sovereignty carries with it the ultimate political-economic power, that of money creation by the sovereign authority – the primary tool of any monetary craft in determining employment and stability levels.
    My fear remains that in avoiding the government-issuance issue n any discussion of reforms, we kick that particular can further down the road, rather than addressing outright how that ultimate authority ought to be implemented, and especially how to make it accountable to the people it is designed to benefit.

  12. Ramanan,
    From your Buiter article: “Again, there is no evidence to suggest that the ECB would, under any conceivable circumstances, knowingly choose to bail out fiscally challenged Eurozone governments through outright purchases of their debt instruments or through equivalent ways of monetising the debt of the fiscally incontinent.”

    Does Buiter think that there is an ECB trading desk in their Frankfort building, and some day the phone will ring there and persons in Frankfort will look at the caller ID and it will be from an area code in Greece and they just wont answer it? Thats not the set up I read about in the Gen Doc.

    Reads to me like that phone call will be a local call in Athens, and the Bank of Greece will take the call.

    Ramanan, do you see any way Greece can get their interest rates down? Perhaps by issuing all short term?

  13. Ralph: Isn’t there much to be said for keeping central banks and treasuries separate in that it stops politicians having direct access to the printing press?

    The legislature already has control over the printing press to a large degree through appropriations, subject to presidential approval, although it is possible to override a veto. The Fed doesn’t control the printing press. All it can do is manage interest rates through monetary operations.

    I agree with Bill that it’s in the spirit of democracy to have elected officials in charge of and therefore accountable for policy. This seems pretty basic to the American system. One might even question whether it is unconstitutional for them to delegate policy-making functions that affect the nation at such a fundamental level. The Fed has violated its specific mandate to pursue full employment AND price stability in setting interest rate policy. This is sufficient grounds for questioning whether so-called independence is freedom or license.

    The Fed is dominated by the banking industry, and the banking industry has a deflationary bias that favors money as a store of value. This bias is not in the best interest of national prosperity or promoting the general welfare but rather in the interest of the wealthy. The result is “inflation targeting” using unemployment as a tool. The Fed also has regulatory responsibilities that it failed to exercise to control the Ponzi finance that led to the crisis, and there’s been no accountability.

  14. JKH,

    Yes lots of permutations and combinations. Who knows there are more such as FX related stuff 🙂


    “Incontinent” was really LOL. But he used to work for the BoE I guess, so nice way to find what his colleagues at other places think etc. The question about issuing short term also interested me but do you have some data ? I think, since short term rates are administered, they (Treasuries) generally keep the supply < demand so that there is no "market clearing" and the government is able to sell at the bills at the rates administered.

  15. In previous comments I observed that public debt yield spreads can vary inversely with austerity measures if markets perceive that GNP growth will decline and probability of default will rise. This goes against the conventional wisdom regarding austerity measures. For those that are interested here is a formulation from my research based on expected shortfall analysis. After some math manipulations I derive,

    i(t)= g(*)+Ī€(t)+(DUR)(t)[E(Ī€(t-1))dĪ€-PR(t-1)(B-DBV)(t)dg]

    i= nominal yield of public debt, g=real GNP growth rate for public debt maturity equivalence, Ī€=inflation rate, DUR=trade duration period, E(Ī€)=expected inflation rate, dĪ€=change in inflation rate, PR=probability of public debt default, B=present value of public debt, DBV=present value of deficit balance to public debt maturity equivalence, dg=change in GNP growth rate.

    Notice that a rise in duration, current inflation rate, current real growth rate and change in inflation tend to increase the nominal yield of public debt. Furthermore, a decrease in real growth from, among other reasons, austerity measures, given the current probability estimate of default, tend to increase the nominal yield against what conventional theory says! For those who are interested I have a more complex stochastic version.

  16. Matt,

    This Reuters report dated March 30 says that Greece will issue T-bills in April. However it says that it is a recurring issuance – some bills expire soon.

  17. In my last comment I omitted something obvious that the real yield, in cases of revenue constrained public debt, incorporates a term for the expected shortfall (risk) given default in addition to the risk free rate. Thus,


    This nominal yield(i) formulation can become more complicated if we allow public debt maturity and duration trade “twists”. Furthermore, it can apply for private debt yield estimation.

  18. Matt,

    But its too late now. The program is over. SICK cnbc was running a funeral dirge as bumper music in honor of the “death” of Quantitative Easing today.

    Exactly. They chose to stretch out 1 trillion over a longer time, rather than spend the trillion by lowering the price to 4%, have it remain there for 2 days, and have rates return to the pre-intervention level on the third day. If homeowners were presented with the opportunity to refinance with rates at 4%, how long do you think the 1 trillion would have lasted? I think 2 days is an upper bound. In that case, very quickly the government would be the sole holder of agency debt, as it would all be rolled over, but no private sector investor would buy that paper — everyone would switch to the other side and be a borrower instead.

    On the other hand, look at the interbank market. There, the CB can drop a tiny amount, say $10 billion, and move rates significantly, and then the CB can *reverse* the operation, and rates will remain at the higher level. Yet for agencies, you need to spend 1000 times as much, and you wear out your eyes trying to detect a statistically significant impact on rates.

    What is the difference? They are qualitatively different. It’s not a question of frictional costs. In the interbank market, banks must meet their reserve requirements, and cannot do so unless the CB provides the funds. A bank leaving or entering this market changes nothing. Now there are frictions — e.g. the eurodollar market, etc . But we approximate this market with a vertical demand curve and the frictions control the time-lag/degree of funds needed to make the change, but not the direction of the change.

    Now look at the capital markets — you are not interested in issuing even $1 of liabilities if doing so costs you more than you able to earn with the funds. And you are willing to borrow an infinite amount if you can make a profit doing so. There are also frictions — e.g. you will only borrow a limited amount, earn your arbitrage profit, borrow more, etc. — but again, that just measures the speed of the adjustment, not the direction.

    In one market, you care about meeting a fixed (government set) quantity requirement that, when idealized, the borrower is unable to control — the government controls it. In another market, you care about meeting a return requirement that you are also not able to control — it is controlled by the expected growth rate of the (real) capital stock. In both cases, the frictions measure the speed of the change in price and/or quantity, but they do not measure the direction of the change.

    Once you understand this model, you wont ever make the mistake of assuming that what the CB is doing in the interbank market is a special case of what it can do in the capital markets. It’s not a question of firepower. Firepower can be used to push against the pendulum, but in doing so, you will only be able to temporarily provide subsidies to one group at the expense of another. As soon as you stop pushing, the pendulum will swing back, and in fact you will have succeeded in destabilizing the real economy. For example, in your example, you want to subsidize homeowners at the expense of renters, and this type of intervention is harmful, and will lead to elevated lending rates (due to a collapse in the housing market) once the subsidies stop. If your goal is to reduce, say, 10 year treasuries, then what you are doing is subsidizing existing asset holders at the expense of future holders (e.g. subsidizing those who are drawing down their stock of assets at the expense of those who are accumulating assets), and also subsidizing those receiving dividends at the expense of those receiving interest payments. In all these cases the flow of money needed to keep the prices at the desired level is equal to the speed with which the privileged group can pick the free money up from the ground.

    Lets see what happpens now.

    I’m not expecting anything to happen, since I don’t think anything was happening before. But again — we are talking about capital markets here, so expect a lot of randomness. It’s absurd to hear “The market rose on talks of..”, or the “the market approves of” this or that. This includes the recent talk of yields increasing. It’s the intellectual equivalent of looking at how many clouds are in the sky today, and determining whether you will have a good harvest.

    But I think for all of those people who are convinced that government interventions in capital markets really control yields, they should think about the following test: try to see if you can truly detect the intervention. I.e. I give you a series of pairs of points (10 year rate, agency rate), but not the date, and you are the oracle specifying whether the government was intervening on that date. Without relying on your own memory of which prices occurred when (and you can keep yourself honest by transforming the pair according to a best fit function so one of variables is always constant — say 6%). With what confidence do you think you could accurately detect a pair that coincided with a government intervention? Could you write a program that could do this with a 90% success rate?

    To me, this is the only meaningful way you can claim that intervention has successfully lowered yields. And then there is the issue of how much money you must continue to funnel to the privileged group in order to keep those rates at that level. Squinting at graphs can’t be the way to do it.

  19. RSJ Hi,

    “how long do you think the 1 trillion would have lasted? I think 2 days is an upper bound.”

    I know you are using hyperbole here, but look we really cant know unless that is what the tasking from the FOMC was. So if you were running this program and they came to you and said, “RSJ, we want you to run the FHA conforming rates down to 4% and hold them there for as long as you can. Here is $1.25T of balances to do it for now, try to make that last as long as you can”. Then we could see how it would go. That was not the task.

    This was the task from the Feds press release of 25 NOV 08: “The Federal Reserve announced on Tuesday that it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises (GSEs)–Fannie Mae, Freddie Mac, and the Federal Home Loan Banks–and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late. This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”

    So I think based on what the task here was, I think they did a pretty good job. They got rates down (just not low enough for me!), facilitated some housing sales, and I think MBS spreads are at/near record lows. In hindsight we can see that their target for conforming mortages was 5.0% and they held this area pretty well. You dont have to go thru the trouble of modeling this you just have to look at the chart.

    Would they have needed more than $1.25T to do the same at the 4% level? You cant say for sure.

    But where did they get the $1.25T number to begin with? Perhaps a clue from the above statement: “and foster improved conditions in financial markets more generally”…I cant prove this of course, but I think they thought that by adding $1.25T of reserves thru this program, the banks would have an additonal $1.25T to “lend out”. Remember they green lighted this program way back in late 2008 when the “shadow banking system” or the commercial paper market (which was estimated to be this exact $1.25T number) virtually disappeared. All top Fed officials at that time were routinely talking about how the banks “lend out the reserves”, and I think they actually thought that these balances in the system would replace the commercial paper market by identity and things would start functioning again. This 1.25T over 12 months number has no ralationship to the historic US mortgage market that I can detect.

    So if you believe this then you can see that they just pulled the $1.25T number out of their you know where and decided to throw it at the Agency MBS market (with 5% mortgage lower bound) as it was Govt bonds and had the added benefit of helping housing. Their irrational/ignorant fears of monetary inflation prevented them (and continue to prevent them) from being more aggressive for legitimate US homeowners.

    You cant model any of this as you dont know the real agenda or rate targets.


  20. Tom: I’m not the world’s expert on how the Appropriations Committee and the Fed work, but my understanding is that the relationship between this committee, the Treasury and the Fed is similar to the equivalent relationships in the UK and Australia, for example.

    I.e. elected representatives can vote for any level of spending and tax they like, but when spending exceeds tax, they cannot actually print money. The Treasury, on instructions from elected representatives or the “Appropriations Committee” can only borrow and issue IOUs (Treasuries in the US) to cover the excess of spending over income from tax.

    The central bank in all three countries can then print money (electronically) and buy these IOUs, if the central banks wants to lower interest rates. Or it can refuse to do this, in which case interest rates will probably rise.

    It can well be argued that the IOUs are little different to money. But strictly speaking IOUs are not the same as money, and on this strict definition, I don’t think treasuries can print money.

  21. RSJ,

    you are too hard on government/CB and too easy on “free” markets. You said:

    In another market, you care about meeting a return requirement that you are also not able to control – it is controlled by the expected growth rate of the (real) capital stock.

    Can the government control /affect expected growth rate of the real capital stock? Definitely yes and it has plenty of means to achieve that and CB is only one of the tools available. So according to your definition of yield curve it automatically follows that government has power to control it. When Bush sent everybody to the shopping mall, has he changed the direction of yield curve? Yes, he did.

    Then lets get to the 30Y expectations of growth rate of capital stock. How relevant is any single data point to the actual future of growth of capital stock? Absolutely irrelevant. Why? Because the probability of 30Y rate being equal to the future realized rate of capital growth is zero at any given point of time. So what makes you think that the market knows something better? If CB keeps on telling the market that the future growth rate of capital stock will be 4% then this market, operated by human beings, might at some point of time start believing it. And words accompanied by some actions might achieve this result much faster.

  22. Sergei,

    This is an issue of being hard or easy on anyone, but understanding how things work. For government the issue is fiscal policy versus monetary policy.

    You are absolutely right that the government has enormous fiscal powers to influence (although I would not say “control”) everything from inflation to income inequality to productivity. This is done by tax policy, building schools, providing health care, a jobs program, effective regulation, labor management policy, etc. All of these things will influence the growth rate of the economy in an important way. Nevertheless, this growth rate is also constrained by endogenous factors such as the rate of new inventions, new substitutions for things we run out of, the economic health of our trading partners, etc.

    But the topic of this thread was monetary policy — buying and selling financial assets at market prices. Monetary policy is ineffectual at influencing investor rates. It can certainly cause shocks — a rate hike to 20% will tank the economy and bring all the long term rates down quickly in the ensuing deflation and contraction. A rate cut may (or may not) cause a housing bubble, in which case there might be a temporary boom and rising long term rates. In both of these cases, the monetary intervention is destabilizing. Instead of building schools and addressing our health-care crisis, the government is busy destabilizing the economy. But at the end of the day, monetary policy can’t prescribe the term structure of rates at every maturity. Expectations of returns will do that.

    If CB keeps on telling the market that the future growth rate of capital stock will be 4% then this market, operated by human beings, might at some point of time start believing it. And words accompanied by some actions might achieve this result much faster.

    This type of “signaling” approach is over-emphasized, IMO. The thing is, people eventually figure out whether they are receiving that 4% or not. And it is economically harmful to try to get the market to misprice returns. That 4% number is not just an abstract thing — it corresponds on the one hand, to a debt obligation that must be met if the business is to continue. On the other hand, that rate of interest also corresponds to the expected return, and any return in excess of that accrues to equity, not labor. So if you underestimate the return, then equity holders receive a windfall, but if you overestimate it, then the business liquidates. When returns are mispriced, then bad things happen. The market already has a hard enough time predicting returns, and trying to add a consistent bias to these errors is dangerous.

  23. Hi Matt,

    The FRBNY staff are doing the best they can, but if someone came to me with a mandate to lower mortgage rates to 4% for a certain period, I would tell them “I can’t do that. I can only buy and sell securities at market prices. I can’t convince someone else to value 10 year money at a certain rate. On the other hand, *you* can simply offer loans to homebuyer at 4%. And you can do this for 1.25 Trillion if you want, or some other number if you want. That is how you control the interbank market — by lending at a certain rate as well as buying assets. You need both. In the end, the difference between the homebuyer cost of funds and everyone else’s cost of funds is a direct subsidy — fiscal policy. The economy will react to this subsidy in the standard ways. We have been sending about 500 billion a year to homebuyers via subsidies anyways. But before you do this fiscal policy, I would ask why you only give the money if the recipient agrees to take out a large debt — it is a harmful policy. Moreover, it primarily causes housing to become more expensive, and it distorts the economy.”

  24. What impact on GOLD would all this have, if he does TWIST? Short term and Long term

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