The Fed has at its disposal one key tool: interest rates. So when Fed officials are worried about unemployment, they try to drive down interest rates, in an effort to encourage people and businesses to borrow and spend. And with unemployment over 9 percent (and core inflation at 2 percent), the Fed is likely to keep hammering away, trying to push down interest rates. The Fed will announce its next move on Wednesday afternoon, at the close of a big, two-day meeting. That move is expected to be something known as “Operation Twist.”
Here’s what it means.
1. The Fed already owns more than $1 trillion in bonds, purchased over the past few years in an effort to bring down medium- and long-term interest rates.
2. A lot of those bonds—hundreds of billions of dollars worth—are medium-term bonds, which come due in the next few years.
3. Interest rates on medium-term government bonds are already near zero.
4. The Fed may sell some of those medium-term bonds, and use the proceeds to buy longer-term bonds—such as 10-year Treasuries.
Operation Twist should, in theory, drive down the interest rate on 10-year bonds. (When demand for bonds rises, interest rates fall.) Lots of other interest rates—including mortgages—are tied to the 10-year Treasury rate. So this should drive down interest rates across the board.
To oversimplify things, banks traditionally make their money borrowing short and lending long, picking up the difference between their own funding costs and the rates they charge consumers and businesses for mortgages and commercial loans. Net interest margins (NIM) rise when the shorter end of the curve has lower interest rates than the long term, so a flattening of the curve is a negative for banks. In a note Wednesday, Evercore Partners analyst John Pancari notes that the flatter curve that comes with an Operation Twist is a long-term negative for banks, with those most dependent on NIM the most exposed. Of course, with the 10-year Treasury yield at just 1.94% it remains to be seen just how far long-term rates can actually fall.
Why are we voting on a policy that makes it even easier to BORROW AND SPEND MONEY WE DO NOT HAVE? Isn’t that what got us into this mess in the first place?