Let’s Twist Again

23/09/2011 at 11:49 am 1 comment

Confronted with a debt-ridden, downgraded economy, the central bank is divided. In the face of sub-trend figures for growth, a minority insist on worrying about inflation. The majority prevail, however, and vote through a plan to intervene in bond markets in one last, desperate throw of the dice.

Yes, it was business as usual at the Federal Reserve this week. And not for the first time, this blog feels a little sorry (but only a little) for the beleaguered leaders of the central bank.

First of all, it is wrong to dismiss this latest intervention as ineffectual. The point is not that the Fed has chosen to maintain the size of its bond buying programme rather than increase it, as some had expected. The point is that by buying – or signalling that it will buy – bonds of longer maturities, it can influence mortgage rates. Unlike the UK, where the mortgage market is anchored firmly to the central bank’s policy rate, US mortgages tend to be sold at fixed rates for terms of up to 30 years. Allowing for prepayment behaviour and various other mechanics of the American mortgage market, this means that the key reference rate is not the central bank rate but the ten year swap rate, over which the Fed usually exerts no control.

Following the announcement of Operation Twist, however, that rate has fallen 20bp. If it holds its current level of a little under 2%, the average US mortgage rate – last reported by Freddie Mac at 4.7% for July – should be expected to fall to around 4.1%. This is well below the 4.5% reached last November, and should therefore trigger a new round of mortgage refinancings, putting extra money in the pockets of existing mortgage borrowers.

Ben Bernanke knows all about this sort of thing, having written more than one landmark essay on the transmission mechanisms of monetary policy. His switch idea should have been an elegant solution: cut the mortgage rate without “printing more money” by adding to the Fed’s aggregate holdings of US bonds, thus stimulating demand while appeasing the (few, bedraggled) inflation hawks.

Unfortunately for Bernanke et al, any understanding or appreciation the world might have shown for this subtly choreographed monetary ballet was swamped by panic over the Fed’s accompanying programme notes. Talking of “significant downside risks” to the US economy and “strains” in financial markets, they were doubtless supposed to provide only the necessary context to the spectacle of the policy response. Sadly for all of us, they stole the show. Bernanke and others should consider how far the wealth effect of the 6% fall in the S&P 500 that has ensued will have taken the shine off any improvement in mortgage rates. And that’s before we consider the monetary impact of the 2% strengthening in the trade weighted dollar as the world stampeded for quality. (Who knows? Perhaps some future Fed Chairman out there will write a landmark essay on the subject.)

It looks as though those tedious old hawks were right, and that the Fed would have been better off without its cunning little bond market ballet. Let’s hope it’s a one off: if they’re right about inflation too, then we’re in serious trouble.

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To The Rescue Lessons From The East

1 Comment

  • 1. A Thousand Cuts « The Blog @ Vigilant Financial  |  06/07/2012 at 4:18 pm

    […] seem to be hitting markets with the same naked terror that it did last autumn. When the Fed announced Operation Twist back in September, for instance – a smart monetary move insofar as it might have contributed to lower mortgage […]

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