What Operation Twist Really Means

10/13/2011 7:30 am EST

Focus: MARKETS

Gemma Godfrey

Head of Investment Strategy, Brooks Macdonald

It may well be the last bullet the Federal Reserve has in its arsenal, and if the jobs bill in front of Congress is killed, the last few months of the year may be just as difficult as the summer, writes Gemma Godfrey of The Investment Insight.

As the US launches its $400 billion "Operation Twist" in a desperate attempt to kick-start the economy, concerns arise over how effective this will be.

It’s true that something needs to be done, and inflation restricts the options open to the Fed, but the strategy has a poor track record in terms of effectiveness. We will be in a lower-growth environment for longer, and should prepare accordingly.

Something Needs to Be Done
The US remains driven by consumer spending (~70% of GDP), but weak consumer confidence and limited access to financing are severe headwinds.

Unemployment is stuck at 9%, and even more worrying are the "underemployment" figures, which include those that have been forced to cut their working week. This has risen as far as 18.5% of the population.

In addition to discouraging spending, the longer this continues, the more skills are being eroded. Therefore the US government is under an immense pressure to act.

But Inflation Restricts Options
So what can they do? When conventional monetary policy has become ineffective, since short-term interest rates are already low, that’s where quantitative easing steps in.

With the aim of stimulating the economy, the Fed will buy financial assets in order to inject money into the markets. Bernanke has made it clear that one of the pre-requisites is a re-emergence of deflationary risks. However, inflation remains stubbornly above 2%.

Pumping more money into the markets increases its supply and therefore reduces its value. With the currency less valuable, it doesn’t go as far as it used to, and you get less "bang for your buck." Things seem more expensive and inflation has been boosted.

Operation Twist to the Rescue?
There is hope. One form of quantitative easing avoids the problem of inflation—Operation Twist. The strategy still involves the Fed buying long term government bonds, but in this case, it’s offset with selling short-term bonds.

This avoids flooding the market with cash, which would exacerbate inflation. Another way this method is also described, by selling short term bonds and buying longer term bonds, is an extension of the maturity of the Fed’s bond portfolio.

Buying these long-dated bonds increases demand and therefore reduces the amount of interest the bond issuer has to offer to entice buyers. A reduced longer-term rate makes mortgages, for example, more affordable, which would hopefully encourage spending.

A Poor Track Record
History teaches that Operation Twist may be of limited use. When it was applied back in 1961, it only reduced rates by 15 basis points! This would not be enough to encourage spending or hiring, nor would it boost the economy sufficiently.

What Can You Do?
Prepare for a lower growth environment for longer. Pay attention to the type of customer a company services when you investigate it for possible investment. A strong balance sheet, pricing power, and protected demand will serve firms well.

Read more at The Investment Insight here…

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