The Fed's Unwinnable War on Unemployment

The Federal Open Market Committee decided to continue its maturity extension program (aka “Operation Twist’) through the end of the year. While this decision represents a victory, of sorts, for proponents of monetary activism, it was well short of what many advocated. The decision was unwelcome news to stock traders (at least at first), who had come to believe something bigger was in store. Stock markets dropped by 0.44% in the 10 minutes following the announcement. In reality, the Fed had a choice between inaction, a pointless gesture, and pointlessness on steroids. They opted for pointlessness.

The Fed committed to purchase an additional $267 billion of longer-term Treasury securities through the end of 2012. “Operation Twist” differs from quantitative easing in that the purchases of these securities are financed by the sale and redemption of shorter-term securities currently in the Fed’s portfolio. As a result, the Fed’s balance sheet remains the same size and no new reserve balances are created at member banks (aka “printing money”).

Yet, with money market interest rates near zero, there is practically no difference between the two policies. In one case, the Fed finances the purchase of a 10-year bond by crediting a bank with a reserve deposit that earns 0.25% interest; in the other, the Fed finances the purchase by selling a 2-year note that yields 0.3%. In either case, the public sector provides the private sector with a low-yielding, short-duration asset in exchange for a longer-term bond. In the best case, these actions have no effect on short-term interest rates because the Fed commits to keep the fed funds rate near zero, while longer-term interest rates fall as longer-term bonds become relatively more scarce.

If you are wondering how or why this kind of portfolio shift is supposed to engineer faster economic growth, you are not alone. Probably the best description of the pointlessness of this operation comes from John Cochrane, who asks:

There appears to be a fundamental disconnect in many quarters between the Fed’s policy goals and the tools at the central bank’s disposal. For example, in a recent New York Times op-ed, former Council of Economic Advisers Chair Christina Romer advocates aggressive Fed action to bring down the unemployment rate. Specifically, she advocates that the Fed announce and commit to meet a nominal GDP target (real growth plus inflation). The problem is – as is commonly the case with such proposals – she does not specify the exact tools the Fed would employ to meet this target. It is one thing to say the Fed should do “whatever it takes” to make this or that goal a reality, it is quite another to specify, point-by-point, what actions the Fed should take and how each of them is likely to work in practice.

If someone decides to set a target weight for themselves, they are generally aware of the relevant “instruments” used to hit that target: diet and exercise. The policy instruments necessary to hit a nominal GDP target are not so obvious. The Fed is limited by statute in terms of what securities it can buy. The Fed cannot buy corporate debt or stocks directly, for example. It can set up a funding facility, as it did for commercial paper and asset-backed securities, but this is different from outright purchases and involves low-cost collateralized lending that these banks can already access today. The Fed is basically limited to buying Treasury securities and the securities issued by Federal agencies, like Fannie Mae and Freddie Mac. It is not clear what added purchases of these securities would achieve.

As of June 18, the real (after expected inflation) 5-year Treasury borrowing rate was -1.2%. This means that after accounting for the erosion of purchasing power caused by inflation, investors are willing to pay the Treasury Department 1.2% per year to store their money. This is not the sign of an economy likely to be stimulated by additional efforts to reduce interest rates.

Moreover, even if lower rates could be engineered, what is the likely economic value of an investment that requires -2% interest rates to get funded in the first place?

For asset purchases to be effective, the Fed needs the investors from whom they purchased the Treasury securities to take that liquidity and invest in risky assets. Without confidence in the economy or outlook, investors choose instead to keep the money conservatively deployed and businesses increase their cash stockpiles. The narrowing of the spread between longer-term Treasury securities and money market interest rates also reduces banks’ incentives to lend given that their business model involves borrowing at short term rates to lend long. As Peter Fisher explains, quantitative easing can also impair credit creation by denying banks and broker-dealers the Treasury securities that serve as the core liquidity and capital in the financial system.

The Fed could legally buy foreign exchange and foreign government securities. Perhaps Romer thinks the Fed should print dollars to buy the sovereign debt of Spain, Italy, Portugal and Greece. Certainly this action on a large scale would remove uncertainty over potential sovereign collapse in Europe and lead to a decline in the foreign exchange value of the dollar, boosting exports and inflation. Yet, such a move would also expose the Fed’s balance sheet to losses, erode confidence in the dollar, and potentially result in a surge in the price of commodities. Absent the creation of similar domestic, loss-making loan programs – such as providing 100% nonrecourse financing to banks that make loans for big ticket purchases – the Fed doesn’t have many options that would make much of a difference.

Fed actions do matter to market psychology, however, which is why the Fed likely opted for pointlessness rather than nothing. If they had failed to extend Operation Twist, market participants would have likely sold stocks, intensifying the recent run of bad economic news and making the calls for more action even louder at the next meeting. But those who criticize the Fed for not pursuing even more radical actions need to think harder about the relationship between policy goals and the actual tools the Fed has to meet them.