The Fed Keeps Twisting in Its Quest for Lower Rates

Driving down long-term rates
Photograph by Brendan Smialowski/AFP/Getty Images

The Federal Reserve will keep spiking the punch bowl at the economic dance party through the end of the year. The Fed said Wednesday it will continue what economists like to call Operation Twist, an attempt to bring down long-term interest rates to stimulate economic growth. The operation “should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative,” the Federal Open Market Committee said in a written statement.

William McChesney Martin, who chaired the Fed in the 1950s and 1960s, once said that the central bank’s job was to “take away the punch bowl just as the party gets going.” But under Chairman Ben Bernanke, the Fed is more worried about the ho-hum party grinding to a complete halt. Rate-setters are trying to push mortgage rates to historic lows to revive the housing market, which is a key to overall growth.

The concept of Operation Twist is to sell some of the Fed’s short-term Treasury securities and use the money to buy long-term ones—to “twist” the maturity of the portfolio. Short-term rates are already super-low; the objective is to bring longer-term rates down as well by shifting demand. The original program, announced last September, was set to expire at the end of this month with $400 billion shifted. Now the Fed will reallocate a further $267 billion toward long-term securities through the end of 2012, leaving it with precisely zero in short-term Treasuries.

While the Fed is twisting, it isn’t quite shouting. Shouting would be taking the more extreme measure of adding to the size of its bond portfolio, which already stands at about $2.7 trillion. The current program shifts the maturity of the portfolio without making it bigger.

Will this help? Probably some, but not a lot. Low mortgage rates—the 30-year fixed rate average is currently 3.71 percent— have already made houses the most affordable they’ve been in decades. The problem for many potential buyers is not the cost, but their inability to get a loan because of damaged credit. The Fed’s initiative won’t do anything about that.

The rest of the Fed’s statement was as expected: It darkened its portrayal of the economy’s health and repeated its prediction that weak economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.” Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, dissented from the open market committee’s decision, opposing the continuation of Operation Twist.

The Fed is now looking for 2012 economic growth of just 1.9 percent to 2.4 percent [PDF], down sharply from the range of 2.4 percent to 2.9 percent in April. That’s the range excluding the three highest and three lowest forecasts. It includes predictions from all of the Federal Reserve governors and bank presidents, not just the ones currently voting on the Federal Open Market Committee. The new unemployment prediction is for a fourth quarter 2012 average of 8 percent to 8.2 percent, up from 7.8 percent to 8 percent.

At a press conference, Bernanke fended off questions about whether the Fed wasn’t doing enough, or was doing too much. His most intriguing answer was in response to a question about a new initiative of the Bank of England–the Fed’s counterpart in Britain–to require that banks lend more to consumers and businesses as a condition for receiving new, long-term loans from the central bank. It’s called the “Funding for Lending” program, and details remain vague.

“We’re very interested in it and we’re certainly going to follow it,” Bernanke said. American banks have been criticized in some circles for taking funds from the Fed and not boosting lending. They say the problem is a lack of demand for loans, not an unwillingness to lend. Bernanke said the Bank of England’s plan may involve a subsidy from the British Treasury. A subsidy would presumably become necessary to compensate the Bank of England if banks defaulted on their loans. BBC Economics Editor James Peston says that, based on what he has been told, “the issue of whether taxpayers will guarantee the scheme is not definitively settled.”

( Updates with economic projections and comments from Ben Bernanke’s press conference. )
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