Facing the prospect of weaker growth and higher unemployment, the Federal Reserve’s Open Market Committee (FOMC) announced last week that it will continue its maturity extension program through at least the end of 2012 rather than allow it to expire. The program—more commonly known as Operation Twist—will see the New York Fed sell or redeem Treasury securities with maturities of less than three years, redeploying the proceeds in the acquisition of long-date securities. As opposed to an expansion of the Fed’s holdings, maturity extension relates to their composition and is balance-sheet neutral.
The intention of the Fed’s rebalancing is to push yields lower by reducing the supply of Treasuries on the open market. All things being equal, that will reduce borrowing costs. On the margins, it will offset the negative impact of government spending on private investment—a “crowding out” effect—by absorbing a part of the Treasury’s prodigious debt issuance.
Aside from the intervention’s stated goals, negative real returns on the risk-free investment will distort the path of capital flows. Not unbeknownst to policymakers, risk-averse investors will extend their hunt for yield to less certain assets as returns on the Treasury decline. By encouraging capital flows, low risk-free rates have already contributed as plainly as cash flow to the recovery in commercial property values.
Responding to investors’ flight from the European periphery, seven- and 10-year Treasuries hit their all-time lows at the end of May. With the exception of 20- and 30-year bonds, inflation-adjusted yields are deep into negative territory as of late-June. With rates already at their nadirs, it begs asking why the Fed would pursue efforts to push yields lower. Beyond the announcement effect manifest in the short-term jolt to the stock and bond markets, it is unclear if the maturity extension effort has paid out any benefits for the real economy.
If rates were significantly higher or the balance sheet adjustments were not being offset by uncooperative fiscal policy, maturity extension might have a stronger rationale. In light of their current levels, what improvement can we expect another 10 or 20 basis points will trigger if access to credit remains constrained? The housing market offers a case in point since record-low Treasuries necessarily imply record-low mortgage rates, as well. The government guarantee of the secondary mortgage market ensures a strong transmission mechanism. But with prospective homeowners unable to qualify for those mortgages in meaningful numbers, it is debatable if low rates fomented any improvement in housing outcomes. It is clear that financially secure homeowners have been able to refinance. Beyond that, net new homeownership has hardly accelerated.
An analysis posted last month by the Bank of International Settlements suggests that maturity extension has been ineffective. Economist Torsten Ehlers found “… the dampening effects on long-term yields at the announcement of Operation Twist 2 seem to have vanished within a month.
Actual purchases by the Federal Reserve, apart from the initial one on 3 October 2011, do not seem to have had additional effects on interest rates.” Looking farther back, economists from the Federal Reserve Bank of San Francisco found that the original Operation Twist of 1961 only pushed rates lower by 15 basis points.
In weighing the relevance of the Fed’s most recent actions, commercial real estate investors and lenders might take a skeptical view. If the program succeeds in testing a materially lower level for yields, any semblance of a private market will have been suspended. Along with it, investors’ and lenders’ capacity for measuring and mitigating interest rate risks will be further impinged.