Operation Twist: Doing Nothing While Looking Busy

I once read that Carl Icahn took over a particular company, brought his team in to assess the inner workings of the firm, and found an entire floor of workers who looked busy, but whose purpose in the firm couldn’t be identified. As a result, they fired everyone on the floor. Nothing changed. Now this story could be a complete fabrication, but I don’t care whether its true. I bring it up because Operation Twist 2.0 is the embodiment of that floor of workers. There is an illusion that something is being done, but in reality, things would be no different if the policy didn’t exist.

Bill Woolsey provides conditional support for Operation Twist based on monetary disequilibrium logic. Here is a brief summary of his argument:

In 1956, Leland Yeager explained the “monetary disequilibrium” approach to the liquidity trap. One core principle of his view is that any general glut of goods, in particular, any drop in the flow of money expenditures on output, must be matched by an excess demand for money. People are trying to accumulate and hold more money than exists.

If we think about the possibility of people trying to sell current output and accumulate some other nonreproducible good, like “old masters” or land, and the result is a shortage, then we must ask what the frustrated buyers do. If they purchase some other reproducible good or service, then there is no general glut of output and nominal expenditure on output is maintained. If, on the other hand, they simply hold money, then the result will be a shortage of money and a general glut of goods. Nick Rowe often writes on this issue.

Suppose the good that people want to accumulate are short and safe financial assets. Suppose people are trying to accumulate T-bills. Yeager pointed out that once the interest rate on those bonds become so low that it isn’t worth the bother of buying them rather than just hold money, then the shortage of them is leaking over into a shortage of money. It is very much like the frustrated buyers of “old masters” choosing to hold money rather than buy something else.

These days, the liquidity trap is identified with the zero nominal bound on nominal interest rates. So rather than this shifting of a shortage of bonds to a shortage of money at a very low positive interest rate, the leakage supposedly happens at zero. The way I would describe the problem is that if the market clearing interest rate on these bonds is negative, and greater than the cost of storing currency, then of course, the shortage of these bonds is going to shift over to a shortage of money.

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What does that imply regarding “operation twist?” By having the Fed sell off its holdings of short term government bonds, the Fed will relieve that underlying excess demand for those securities and lessen any shift of that excess demand to an excess demand for money. It should help relieve the monetary disequilibrium. Of course, if the Fed reduced the quantity of base money, as would be the usual consequence of an open market sale, then any decrease in money demand would be offset by a decrease in the quantity of money. However, by purchasing long term bonds, the Fed sterilizes the impact of the sale of short term bonds on the quantity of base money.

The other way to look at the issue is that with nominal interest rates on T-bills (nearly) at zero, they are perfect substitutes for money. By selling T-bills and purchasing long term government bonds so that base money does not decrease, the total quantity of money, T-bills held by households and firms and base money, increases. This will tend to relieve the excess demand for money.

While Bill is correct in his discussion of Yeager and monetary disequilibrium, I think that he is wrong in the assessing the efficacy of the program. In theory, Operation Twist could potentially relieve monetary disequilibrium by expanding the supply of short term safe assets. However, since the Federal Reserve is paying interest on reserves, they have effectively placed a ceiling on short term yields.

To understand why this is important, consider the effects of Operation Twist conditional on the assumptions Bill makes: (1) there is an excess demand for safe assets; (2) the excess demand leaks into money demand; (3) the increase in money demand leads to a reduction in spending and therefore nominal income. Now suppose that the Federal Reserve sells $X of T-bills uses the proceeds to buy $X of long term bonds. In doing so, the price of T-bills fall and the yield correspondingly rises. However, this generates an arbitrage opportunity for banks, which will use excess reserves (now paying a lower rate of interest than T-bills) to buy T-bills. They will continue to do this until the price of T-bills is bid up such that the yield on T-bills is equal to the interest rate on reserves. The degree to which the new reserves created by the sale of T-bills are used to purchase T-bills will be determined by the price elasticity of demand.

The transmission of monetary policy works through changes in relative asset prices. The relative price effect generated by this policy is minuscule. One can always argue that the sale of T-bills increase the supply of short-term safe assets by $X, but the only effect is a pure arbitrage opportunity that ultimately changes the distribution of T-bills and reserves, but leaves the total relatively unchanged.

This is not to say that Operation Twist 2.0 can’t or won’t have any effect. However, for it to be successful, it would have to relieve the excess demand for safe assets. The Fed has committed to a specific value of purchases. Is there any reason to believe that the magnitude of purchases announced by the Fed is enough to relieve that excess demand? Who knows? Therein lies the problem.

The biggest problem with current Federal Reserve policy is that it lacks any coherent direction or policy goal. Expectations matter. (Read Woodford, for heaven’s sake! This is supposed to be mainstream monetary theory.) For Fed policy to be successful, they need to outline an explicit goal for policy in the form of a target for nominal income and the price level and commit to using the tools at their disposal to achieve that goal. Random announcements of specific quantities of asset purchases provide no guidance and will not be effective. Temporary monetary injections are not successful for much the same reason that temporary tax cuts are not successful (see Weil, “Is Money Net Wealth?”, 1991). Without a coherent goal or strategy, monetary policy with all its fits and starts will continue to fail.