Will the Treasury Screw the Fed's Twist?

The government may take advantage of ultra-low interest rates, dampening the central bank's stimulus

The government may take advantage of ultra-low interest rates, dampening the central bank's stimulus

600 geithner bernanke REUTERS Jonathan Ernst.jpg

The federal government could thwart the Federal Reserve's attempt to stimulate the economy. Why would it do such a thing? Doesn't it desperately want to see unemployment decline and to avoid a double dip? Yes, but it also finds ultra-low long-term interest rates too great of a deal to pass up as deficit concerns mount.

Unwinding the Twist

If you follow this stuff, then you know that the Fed intends to engage in a new policy starting next month. It will sell short-dated Treasuries and use the proceeds to purchase $400 billion in longer-term Treasury securities over nine months. Commentators refer to this program as "Operation Twist."

The purpose of the action is to push down longer-term interest rates by creating additional market demand for longer-dated securities. As the theory goes, this should encourage more longer-term lending, which would stimulate the economy.

But here's the problem: the outstanding supply in the market would have to remain near-constant for the additional demand the Fed is creating to have the most impact. As long-term interest rates hit historical lows, the Treasury might feel the urge to issue additional longer-dated debt. Doing so would provide its borrowing significant long-term stability and very low borrowing costs over that extended period.

Think about what would happen here. Let's say interest rates are at 4% and the Fed imagines that its purchase of $45 billion in longer-term Treasury securities per month will lower rates to 3.5%. If the Treasury increases its issuance to match the Fed's buying, then that effect will be lost: the Feds additional demand for longer-dated securities will merely soak up the Treasury's additional supply, leaving interest rates unchanged.

Will the Treasury Dampen the Stimulus?

Rich Miller at Bloomberg reports that the Treasury may, in fact, create the a headwind for the Fed's program. He writes:

Under Geithner, the Treasury has been pursuing a policy of extending the maturity of the government debt outstanding by issuing a greater proportion of longer-dated securities. The average maturity of U.S. debt rose to 62 months in the second quarter of this year from 49.4 in the first quarter of 2009.

The Treasury signaled on Sept. 21 that it will not deviate from that path in the wake of the Fed's move.

He continues by citing a source who indicates that the Treasury will probably issue $430 billion in debt with maturity of at least 10 years in 2011 -- about the same amount as in 2010. If that's the case, then the Treasury certainly won't allow the Fed's twist soak up a huge amount of existing supply: its new issuance alone will amount to about $36 billion in longer-term Treasuries per month, accounting for at least 80% of the Fed's purchases.

But long-term interest rates have remained low while the Treasury's issuance level has been steady at this pace for nearly two years. Since the Fed's demand for longer-term Treasuries would be entirely new, it should succeed in pulling down interest rates despite the Treasury's strategy.

Of course, focusing on the twist also entirely ignores the Fed's other action announced last month: it will use maturing principal from its portfolio of mortgage securities to purchase additional mortgage-backed securities, leaving its mortgage bond portfolio's size unchanged. This will help to pull down mortgage interest rates, which could encourage refinancing and home sales. The Treasury's issuance would have no impact on this policy, and its monthly purchases could match or exceed that of Operation Twist.

Is the Treasury's Strategy Really Such a Bad Thing?

The Treasury should be issuing as many long-term securities as it reasonably can without creating too great of an obstacle for the Fed. Over the next few decades, the U.S. is going to have to undergo some serious fiscal reform. As we've seen over the past year, cutting deficits in Washington is not easy business. Since the process is so difficult, having cheap borrowing costs in place for a few decades will provide the U.S. the time it almost certainly needs to work through the politics involved to the nation get off its unsustainable path of borrowing.

In the short-term, unemployment may be the biggest problem that the U.S. faces. But in the long-term, the national debt is also a very serious problem. Through a modest strategy of selling more longer-dated securities, the Treasury will still be allowing the Fed to attempt to provide some relief with its new policies while acting in the best interest of taxpayers.

Image Credit: REUTERS/Jonathan Ernst