Mike Periu explains the Federal Reserve’s latest move. Operation Twist Leaves Economy In Knots
One of my favorite shows on television is Mike Rowe’s Dirty Jobs which airs on the Discovery Channel. Mike travels the country putting himself in the shoes of people that perform dirty but necessary jobs—I’ve seen everything from dead crustacean removal to hog rustling. Given the way things are going with the economy lately, I would like to propose they cover the following dirty job: Chairman of the Federal Reserve. Ben Bernanke may have the “dirtiest but necessary” job in the country right now.
A job that nobody would want to have today
Chairman Bernanke finds himself in a highly unenviable position. As head of the Federal Reserve, his mission is to ensure that unemployment and inflation stay in check. He has multiple tools at his disposal, with the main one being the ability to manipulate interest rates. (I’ve written about how that works before.) By manipulating interest rates to go up, inflation is reduced. The opposite—interest rates going down—causes unemployment to go down. Low interest rates make it cheaper for companies to borrow money to expand which in turn gets people hired.
Despite the Federal Reserve’s efforts, unemployment remains quite high, hovering above 9 percent. The problem is that interest rates are already very low. The 10-year Treasury yields a paltry 1.84 percent as of this writing. That means that if you loan the Federal government money for 10 years you will make less than 2 percent return per year on that money. That’s less than the rate of inflation. Shorter maturities are paying almost no interest at all.
Why are rates so low?
The reason rates are so low is because investors around the world are extremely concerned about the state of the global economy. The safest investment to date continues to be debt instruments issued by the federal government of the United States. The law of supply and demand does the rest. As hundreds of billions of dollars pour into U.S. Treasury securities the “price” of these securities goes up. Regardless of the price an investor pays for a bond, the interest or coupon that the bond pays stays the same. Therefore they have to pay a lot more to earn the same amount of interest. This interest, expressed as the percentage yield, will continue to fall until the demand for U.S. Treasuries returns to normal.
Despite these incredible low rates unemployment remains high. Clearly the problem doesn’t lie with interest rates. But to a hammer every problem looks like a nail so the Federal Reserve will once again try to lower rates even further.
Operation Twist explained
In a tactic known as “Operation Twist”, the Federal Reserve will add to the over $1 trillion in U.S. Treasury securities it already owns. Specifically, it will buy 10-year Treasuries and other longer-term instruments in massive quantities. This will artificially increase demand for the securities, leading prices to rise and yields to fall. This in turn will lower interest rates since many variable rates are tied to the yield on the 10-year U.S. Treasury.
