Is the Federal Reserve's Operation Twist a failure? The stock market plunged in disappointment when it was announced. Keynesians are tearing their hair out in frustration, as it appears the Fed failed to ramp up the printing press. Free marketers are disgusted by the blatant manipulation of the yield curve.
A number of Fed President Bernanke’s colleagues dissented and/or are voicing public opposition. However, as the dust settles, it appears there is a method to the Twist: Bernanke may have a plan...
First, to understand where we are going, you need to understand where we are. The Fed has already been “twisting” its holdings of Treasury securities. It used to be that over 50% of Treasuries held by the Fed had a maturity of less than a year. That portion has already shrunk dramatically. Operation Twist is going to replace many of these shorter-dated securities with longer-dated ones. Differently put, Operation Twist really is nothing new, but an extension and expansion of policies in place since 2008.
To understand Bernanke, you need to look at his playbook, which is hiding in plain sight: In his 2002 speeech that earned Bernanke his nickname as "Helicopter Ben," he laid out his plan when faced with the threat of deflation. Whereas his predecessor Paul Volcker took years to convince the markets that the Fed was serious about fighting inflation, Bernanke appears to be relentless in trying to convince the markets that deflation is not going to happen in his back yard. But why not simply print more money as the economy has slowed (engage in "QE3")?
For the moment, Bernanke at least wants to maintain the appearance of keeping long-term inflation expectations low. Earlier this year, Bernanke complained a few times that the risk/reward ratio of another round of easing is not all that clear. He has made that clearer by crushing the short end of the yield curve with the statement that the Fed will keep interest rates low until the middle of 2013 and then by lowering interest rates with Operation Twist.
Add the overall gloomy economic data, and conditions may be ripe for inflation expectations -- as priced into bond price differential with and without inflation protection -- to drop.
The Fed may have contributed to an environment closer to what Bernanke would like to see: With inflation expectations low, Bernanke is back in familiar territory, able to print more money. One reason the Fed first needed to set the stage is because the Federal Open Market Committee (FOMC) has a couple of outspoken hawks who, as we have alluded to, are not afraid to voice their dissent.
Incidentally, the 2012 FOMC composition reflects that hawks are snowbirds; only one hawk will remain. A stranded hawk may be noisy (dissent and speak out) but might stand little chance against a flight of doves.
Let's go back to the Bernanke playbook; all quotes below are taken from his 2002 speech:
- "First, the Fed should try to preserve a buffer zone," i.e., an implicit or explicit inflation target between 1 and 3 percent.
- "Second, the Fed should take most seriously... its responsibility to ensure financial stability."
- "Third... the central bank should act more preemptively and more aggressively..."
Bernanke may also want a weaker dollar:
- "US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press... that allows it to produce as many US dollars as it wishes at essentially no cost."
- "By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar..."
- "The Fed has the authority to buy foreign government debt... Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of US."
While Bernanke cautions that the Fed might step on the toes of the Treasury by targeting a weaker US dollar, he actively embraces a weaker currency as a tool to spur nominal growth. Bernanke’s primary concern appears to be, not one of determination, but one of calibration: "One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies."
Enough said. While the markets have been "disappointed," when push comes to shove, Bernanke has stuck to his playbook. He has paved the way for QE3. We have argued that there may not be such a thing as a safe asset anymore, and that investors may want to take a diversified approach to something as mundane as cash. Investors may want to actively manage their US dollar risk, be that for their domestic or international investments. After all, investors may want to position their portfolios to take into account the risk that Bernanke will do what he has said.
A longer, original version of this article can be seen on the Merk Funds Website.