I have long been amazed how often people argue that low-interest rates don’t help the economy. And to be honest I once wandered over to the monetary dark side and wrote a post wondering, because of the confidence issue, whether keeping rates low for such a long period of time was helping the economy. But I have tried to repent since. After writing that post and digging around I found that even people who disagree with Federal Reserve Chairman Ben Bernanke latest policy moves still agree on one common principal – lower interest rates stimulate the economy.
So I am surprised myself that I am about to write the next sentence. I think Operation Twist, the nickname (it already has a nickname, ugh) for the Fed’s latest plan to boost the economy, which was unveiled on Wednesday, could be a bust, or at least a dud. That’s because the plan seems to have a fatal flaw. Here’s why:
The plan is called Operation Twist because the idea is that it will twist the yield, or interest rate, curve. How does it work? The Federal Reserve will buy $400 billion of long-term Treasury Bonds between now and June (about $50 billion a month). At the same time the Fed plans to sell short-term bonds in the same amount – $400 billion or $50 billion a month for the next eight months. Selling short-term bonds should cause the price of that debt to fall, and drive up short-term interest rates. Buying long-term bonds should push the price of that debt higher, and cause long-term rates to fall. And that my friends is the so-called twist. Although it will probably work like a steamroller, flattening out what is the normal upward slope of the yield curve, which typically goes from low to high as you go from short to long. The idea is that lower long-term rates should get companies and individuals to borrow more, because the longer I can borrow more at a low rate the cheaper it is, and therefore the more likely I am to borrow. But the problem is that plan comes with a major flaw: Banks.
(SPECIALS: A Stimulus Report Card)
You may have noticed but the banks – particularly the large ones – aren’t doing so well recently. On Wednesday, Moody’s downgraded the credit rating of Bank of America, Citigroup and Wells Fargo. I have a story in this week’s TIME magazine on the state of the banks, and why just three years after Lehman we are facing another potential banking crisis. There are a number of reasons the banks are ailing. But one of them is low-interest rates. Banks live off of being able to borrow short and lend long, and pocket the spread. The recent flattening of the yield curve has hurt bank profits. The twist will only make that worse. The banks, trying to rebuild their balance sheets after the financial crisis and to meet new regulatory requirements, have been preserving their capital and not lending. A further hit to profits could cause banks to hold back even more. And so the twist of Bernanke’s stimulus plan is that we could get less lending, not more.
(MORE: Is Bank of America a Zombie?)
If the choice was between Operation Twist and nothing – and to be fair the Fed is doing a number of other measures including continuing to hold onto mortgage bonds (Ezra Klein did a nice run-down of the all the Fed moves that were announced on Wednesday) – then I think Bernanke made the right choice. The economy is dangerously close to slipping into a double dip recession. He had to do something. Lower long-term interest rates are bound to help the economy somewhat.
But it would have been much better if the Fed had just bought more long bonds, and forgot the twist. Another round of so-called quantitative easing might have driven down long-term bond rates and somewhat preserved the mild upward slope of the yield curve. When QE2 – the last round of Fed stimulus – was announced, the yield curve actually steepened, which is good for the banks, and typically signals a strengthening economy. That is unlikely to happen this time. I know why Bernanke didn’t do that. Because the hawks think another round of QE would be inflationary. Inflation, though, remains at historic lows, and with the economy stalling out like it has recently, there is no real threat of inflation in the future. Yet, Bernanke got spooked. So he took the middle ground. But with 14 million people out of work, half measures to boost the economy are not what we need right now.