What happens if the Federal Reserve leaves out the punch bowl, but stops the dancing?
The gist of the commentary as Fed policy makers gather for a two-day meeting Tuesday has the U.S. central bank maintaining its conditional promise to leave interest rates exceptionally low through to the end of 2014, while steering away from a third quantitative easing program. As long as the economy shows forward momentum, and inflation remains in check, the Fed is in a holding pattern – although a holding pattern with the throttle pretty close to maxed out.
But what does that mean for Operation Twist? That’s the policy trick named after the dance craze that the Fed implemented last year to keep some downward pressure on interest rates. Rather than create money to buy bonds, it said it would sell $400-billion worth of shorter-term assets to buy longer-term ones, “twisting” the yield curve and making it more attractive to borrow over longer periods.
Operation Twist came with an end date: this June. There is some debate in financial markets about whether ending Operation Twist would constitute a tightening of monetary policy. Janet Yellen, the No. 2 at the Washington-based Federal Reserve Board, says no, it wouldn’t.
Sébastien Lavoie, an economist at Laurentian Bank in Montreal, isn’t convinced financial markets will see it that way. Ms. Yellen’s assertion challenges logic. The yield on 10-year U.S. debt fell to a record low of 1.67 per two days after Operation Twist was announced Sept. 23, and yields have remained low. Therefore it seems reasonable to assume that ending the program would put upward pressure on borrowing costs.
Mr. Lavoie accepts that the Fed is uninterested in further stimulus measures at this stage. But if it’s serious about locking in the accelerator at its current setting, then he thinks the policy committee should announce this week that it will extend Operation Twist. Waiting until June only risks market volatility as investors try to anticipate the Fed’s intentions.
The argument that ending Operation Twist isn’t the same as tightening monetary policy, “might be difficult to digest from the equity side,” Mr. Lavoie said. And weaker stock markets certainly aren’t part of the Fed’s strategy. “It’s better to extend the Twist now,” Mr. Lavoie said.