I read an article in the Financial Times earlier this week (September 23, 2023) -…
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!
My band is playing tonight so …
That is enough for today!