Economic First Look: Operation Twist ... and Doubt

 | Sep 19, 2011 | 6:00 AM EDT
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  • Housing Market Index, 10 a.m. (All times EDT)


  • FOMC Meeting
  • Housing Starts, 8:30 a.m.


  • Existing Home Sales, 10 a.m.
  • EIA Petroleum Status Report, 10:30 a.m.
  • FOMC Meeting Announcement, 2:15 p.m.


  • Jobless Claims, 8:30 a.m.
  • FHFA House Price Index, 10 a.m.
  • Leading Indicators, 10 a.m.


  • No major economic indicators

The upcoming Fed meeting dominates this week's economic data. It seems as if everyone anticipates the Fed taking action to stimulate the economy, perhaps with Operation Twist, in which the Fed twists the yield curve by attempting to bring long rates down and short rates up by reallocating its Treasury holdings out of short-term paper and into long-term paper. The thesis is that lower long-term interest rates can help the economy by making interest rates on longer-term debt cheaper, including mortgages, corporate bonds, small business loans and other credit products. In a sort of bad-news-is-good-news reaction, the market has rallied on anticipation that these moves may stimulate demand for riskier assets (including stocks, commodities and so on), and spur credit growth to drive the economy forward.

Another thing the Fed might do -- and this is debatable -- is reduce the interest rate it pays on bank reserves, now at 0.25%, in hopes that banks will lend the funds instead of depositing them with the Fed. This may present problems, however, for some interest-bearing deposits, as there would be less (or no) income to pay the fees to operate those short-term savings programs.

The Fed may very well enact Operation Twist -- I'm not saying it won't. But I'm not betting my life savings on the hope that the Fed will announce some dramatic action Wednesday, as I am not 100% convinced that it will commence a major move now. Also, I don't think Operation Twist will help the economy, though it may spark a rally in stocks and commodities, the source of many inflationary pressures since the Fed first took action.

Let me explain why I have doubts.

Inflation is at the top of the Fed's 2% target range, with the latest CPI report showing headline inflation advancing 0.4%, and core up 0.2% on the month and up 3.8% and 2.0% year over year, respectively. Inflationary pressures may ease but, right now, that's not happening. In fact, the New York Fed's Empire State Manufacturing Survey shows the six-month forward-looking Prices Paid and Prices Received metrics both moving higher: 54.4% of companies expect to pay higher prices, while just 1.1% expect to pay lower prices, sending that index to 53.26 in September from 42.39 in August. Those companies also intend to pass along the price increase to customers, with that metric advancing to 22.83 in September from 15.22 in August. These numbers are not necessarily high by standards of the past year, but they don't show price pressures are easing, either.

Similarly, the Philadelphia Fed manufacturing measure did not show easing price or cost pressures with roughly similar results in its survey. Small businesses, as reported in the National Federation of Independent Businesses' Small-Business Optimism Index, don't seem as capable to pass along the higher costs of their goods to end customers, so any increase in inflation ends up hurting Main Street. And consumers can ill afford price increases right now; the Bureau of Labor Statistics said Thursday that real weekly wages fell by 0.8% from July to August, factoring in hourly wages, hours worked and inflation.

The Fed needs to be vigilant about inflation, and expectations do matter -- perhaps just as much as inflation does. The University of Michigan's Consumer Sentiment Survey showed that inflation expectations for the next five years (the measure watched by the Fed) ticked up again, to 3% from 2.9%. So far, the increase in inflation expectations has been moderate, but the perception that Fed's actions caused higher gas, food and other prices could cause inflation expectations to become unmoored. Higher inflation expectations can cause actual inflation to increase. To the extent that any further Fed action might cause -- or be perceived to cause -- a run-up in commodities prices would be detrimental.

Against this backdrop of potential risks, what are the rewards? For consumers, mortgage rates are already very low; those who were able to refinance at lower interest rates likely have already done so. Many homeowners do not qualify to refinance, given that 10.9 million, or 22.5%, of all residential properties with a mortgage had negative equity at the end of the second quarter of 2011, according to a report this week from CoreLogic. Meanwhile, the decline in mortgage rates to record lows hasn't boosted housing sales substantially, so I question whether lower rates will even make a huge difference for sales.

For small businesses, The NFIB report showed that only 4% indicated the level of interest rates as their primary concern. Only a net 5% indicated that now is a good time to expand, and just 2% cited financing and interest rates when indicating a reason not to expand. Half said they did not want a loan, but the NFIB said that another 15% didn't answer that question, so, presumably, they do not want to borrow at any price.

Large companies, meanwhile, have ample cash on their balance sheets. Many have raised funds through credit markets, and still-lower rates are unlikely to cause many large companies to borrow more to expand. If anything, some companies may return some of that cash to shareholders through dividends, share repurchases or debt reduction if finding a profitable means of expansion is a challenge. The Business Roundtable, which represents very large companies, made no mention of lower interest rates in its most recent "Roadmap for Growth," their wish list to policymakers.

Instead, both the Business Roundtable and the NFIB focused their attention on fiscal matters and lawmakers in Washington. The issue holding companies back, aside from a lack of sales, is uncertainty about taxes and regulation, not monetary policy tools, both groups say.

Which is what Fed chief Ben Bernanke has been saying all along: Lawmakers need to step up and take necessary action, as the Federal Reserve's tools are unable to address these issues. Thus, when the Fed meets this week, whether or not it takes action, remember that monetary policy is not the problem -- or the cure -- for our economy.

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