3 reasons the Twist might be misguided

The Federal Reserve's Operation Twist seeks to bring long-term interest rates down closer to the level of short-term rates. But people in money market accounts and other short-term bank deposits might find that the Fed is trying to twist the wrong side of the equation.

Here are three reasons why Operation Twist may be misguided:

1. A flatter yield curve would emulate conditions that precede recessions. By pushing long rates towards short-term interest rates, the Fed is seeking to flatten the yield curve, or reduce the spread between long and short rates. It is true that this spread is unusually wide: historically, the difference between 10-year Treasury yields and one-year Treasury yields has been 0.90 percent. As of the day of the Fed's announcement of Operation Twist, this spread was 1.77 percent. Here's the thing about flattening the yield curve, though: Prior to each of the last 10 recessions, the spread between 10-year and one-year Treasuries was below normal. That's not to say that flat yield curves cause recessions, but they sure don't seem to prevent them. On the other hand, the yield spread was above normal coming out of eight of those 10 recessions. Curiously, then, the Fed's policy seems bent on emulating conditions which lead into recessions, not those which lead out of them.
2. Both short and long rates are already well below normal. The idea that lower interest rates will stimulate demand is getting pretty stale. Interest rates have already been extraordinarily low, without sparking the spending spree the Fed keeps expecting. Since the early 1950s, 10-year Treasury yields have averaged 6.27 percent; on the day that Operation Twist was announced (September 21), they were down to 1.88 percent. One-year Treasury yields have averaged 5.36 percent historically, but these were a mere 0.11 percent on September 21. Classically, low interest rates are seen as stimulating demand, but this is not your classic economic slowdown.
3. Short rates are even more out of whack with inflation than long rates. What is striking about both long-term and short-term Treasury rates is that they are both well below inflation. This is not unprecedented, but it is unusual. Historically, 10-year Treasury yields have averaged 2.53 percent above the prevailing inflation rate; following the announcement of Operation Twist, they were 1.88 percent below inflation. Short-term Treasury yields were even worse off. Historically, one-year Treasury yields have averaged 1.62 percent above inflation. Following the announcement of Operation Twist, they were trailing year-over-year inflation by 3.65 percent. Only twice before, during the inflation spikes of the 1970s and early 1980s, have short rates fallen so far behind inflation. All of this implies that short rates in particular would need to rise to get more into alignment with the current inflation environment.

Here's a thought--if the Federal Reserve still isn't afraid of a flatter yield curve, maybe it should get there by raising short-term rates while leaving long rates where they are. MoneyRates.com has already documented that bank depositors have lost more than $300 billion to inflation (as of this past spring) because of unnaturally low money market rates and other deposit rates. Raising short rates while keeping downward pressure on long rates could be stimulative because it would help people in money market accounts and other deposits start to earn more interest again, without raising long-term borrowing rates.

 

 

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