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Economy Sep 22, 2011

Operation Twist: Fed’s $400 bn unlikely to revive markets

By Firstbiz Editors

Well, he did it again. In a widely expected move, US Federal Reserve chairman Ben Bernanke announced a third round of monetary easing to stimulate a lukewarm US economy.

Operation Twist, a stimulus move reviving a policy from the 1960s, involvesselling $400 billion in short-term Treasuries in exchange for the same amount of longer-term bonds. The operation will start in October and end in June 2012.

While the move does not mean the Fed will pump additional money into the economy, it is designed to lower yields on long-term bonds, while keeping short-term rates little changed.The intent is to push down interest rates on everything from mortgages to business loans, giving consumers and companies additional incentive to borrow and spend money. In addition, the Fed also said it would reinvest proceeds from maturing investments in mortgage-backed securities. Previously, the Fed had been reinvesting that money in Treasuries instead. The aim is to keep mortgage rates low and stimulate the housing market.

While the move does not mean the Fed will pump additional money into the economy, it is designed to lower yields on long-term bonds, while keeping short-term rates little changed. AFP

Financial markets had already priced in the move, so the announcement took no one by surprise. In fact, disappointed investors thought Operation Twist would do very little to boost the economy- and dumped stocks.

Their scepticism is not unwarranted: an earlier round of quantitative easing, also known as QE2, did precious little to boost the US economy; instead, it arguably contributed to raising speculative inflows into commodity and asset markets, while increasing inflationary pressures in emerging economies.

Nevertheless, a few key points must be noted.

One, a change in the tone of the Fed's language on the economy has raised alarm bells for investors. "Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated," the Fed said in a statement. "There are significant downside risks to the economic outlook, including strains in global financial markets." The markets are interpreting those "strains" to mean the snowballing sovereign debt crisis in Europe.

Although US banks and financial institutions have very little direct exposure to Greek debt, they are intricately linked to European banks that could possibly lose billions should the Greek government decide to default on its massive debt. There is little that US officials can do to prepare the financial system if there be a large-scale economic breakdown in Europe. The pessimism on the US economy's outlook has also stunned investors.

Two, the Fed's attempt to keep interest rates at low levels will do little to encourage credit. That's because interest rates were never the problem for the US economy in the first place. As analysts at Capital Economics in the US argued: "The cost of borrowing simply isn't the problem. Businesses don't have the confidence to invest and half of all mortgage borrowers don't have the home equity needed to refinance at lower levels." The new round of easing will not help to improve either situation.

Three, Operation Twist is unlikely to change consumers' reluctance to spend, since high unemployment continues to diminish people's confidence in the economy. "Homeowners are relatively insensitive to mortgage rates when they are lacking confidence," Yale economist Robert Shiller, an expert on the housing market, told Bloomberg News. "The dramatic thing that is happening now is that their job isn't secure, if they even have one." The Fed's action will do little to address that job insecurity.

Four, with the economy remaining sluggish after repeated monetary easing attempts, dissent among the Federal Reserve Open Market Committee members about further policy accommodation is growing. The Fed's vote was 7-3, indicating that the chairman is also becoming comfortable with taking majority-decision actions and moving away from consensus.

Indeed, there are increasing doubts about what further monetary policy action can do among several experts. In the past few days, several Republicans alsourged the Federal Reserve to refrain from taking any further action. With the impact of Operation Twist expected to happen "only at the margins," "...Bernanke has achieved a rare universal condemnation, with the possible exception of the short-sellers," a report in marketwatch.com, a US financial markets tracking website, noted.

Five, for now, there's unlikely to be any large gush of liquidity into emerging markets. Global investors are too preoccupied with what is happening in Europe to care about pouring in money into emerging markets.Indeed, Asian markets are tanking this morning, as pessimism of the Fed's assessment of the US economy stung investors.

As far as India is concerned, most foreign investors are underweight on the country -- and that perception is unlikely to change. Inflationary pressures continue to dog the slowing Indian economy, and will keep foreign inflows muted.

Mark Vitner, senior economist at Wells Fargo summed it up best when he said: "It's (Operation Twist) not the missing link to an economic recovery."

Not for the US - and certainly not for the world.

by Firstbiz Editors

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