As expected, the central bank will attempt to stimulate the economy by pushing down longer-term interest rates, but it surprised us by announcing some housing stimulus
How do you stimulate the economy without spending any money? You do the twist and shuffle. The Federal Reserve announced Wednesday that it would engage in a new policy known as "Operation Twist," consisting of selling shorter-term Treasuries and using the proceeds to buy longer-term government bonds. This was widely expected, but it also announced a new effort to push down mortgage rates, in particular. The two-day meeting appears to have been a lively one.
The Fed's economic report was little changed from August. But since the recovery remains so anemic, the monetary policy committee decided to take action. Here's the section of the Fed's statement that everyone will be talking about:
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.
Let's start with that first part -- Operation Twist. It will occur over the next nine or so months. That breaks down to around $45 billion per month in swapping out shorter-term bonds for longer-term bonds. Compared the last round of quantitative easing, that's fairly modest. That stimulus consisted of the purchase of $75 billion in longer-term securities per month to total $600 billion over eight months.
The maturities of each side of the twist are interesting to note. This effort will involve the purchase of significantly longer-term securities than the last round of quantitative easing. That round was focused on the purchase of bonds two to 10 years in maturity. Here, they're targeting six- to 30-year notes. Part of the reason for the slow purchases could simply be a supply constraint -- there just aren't that many longer-term securities available compared to shorter term notes. It will be interesting to see if the Treasury increases its longer-term debt issuance to take advantage of what are likely to be historically low longer-term bond rates.
The Mortgage Bond Shuffle
But the other action announced by the Fed shouldn't be overlooked. Previously, it was reinvesting its maturing mortgage securities in new Treasuries. By instead targeting agency mortgage securities, it will more directly push down mortgage interest rates. The size of this effort is not provided, in large part because its size will depend on external factors.
As prepayments from mortgage refinancing increase, so will the amount of money the Fed will reinvest. And with mortgage rates heading towards historical lows due to this campaign, you should expect to the Fed provided lots of principal with which to reinvest. It wouldn't be surprising to see $40 to $45 billion per month in reinvested in agency mortgage securities through this effort. That's about the amount of monthly maturing principal reinvestment from mortgage securities we saw last year as rates were dropping. So this effort could actually outweigh Operation Twist.
The Dissenting Continues
While the Fed ultimately decided to execute Operation Twist and the mortgage shuffle, not all monetary policy committee members were on board. Like in August, three members dissented with the decision -- Richard W. Fisher (Dallas Fed President), Narayana Kocherlakota (Minneapolis Fed President), and Charles I. Plosser (Philadelphia Fed President). Although the statement did not indicate their reason for dissent, they likely worry that the Fed's latest attempt to propel the U.S. economy forward could make it harder to keep inflation under control in future months.
We'll have to wait to see whether or not these latest actions by the Fed help. The market
will surely be pleased. wanted action, but appears less than enthused.* Unfortunately, the Fed can only push down interest rates -- it cannot force businesses or consumers to expand credit if they do not think additional growth or spending is a wise strategy at this time. During its last stimulus campaign, the U.S. economy only grew at the paltry rate of 0.7% in the first half of 2011. Let's hope that the Fed's latest action provides better results.
* Update: It looks like the market wanted more. The Dow Jones Industrial average fell about 80 points initially on the news, and recovered briefly. By the end of day, it was down around 270, more than 2%. Wall Street definitely wanted something more aggressive.
Image Credit: REUTERS/Scott Audette