Have the Fed's massive interventions to keep down long-term interest rates failed to neutralize expectations driving the bond market behavior?
The answer from some of the Fed's leaders would be an emphatic "no." They believe that their "operation twist" (buying long-term bonds by selling short-term Treasury securities from September 2011 to December 2012), and the $85 billion monthly purchases of long-term bonds and mortgage-backed securities have been "successful."
That is as one might expect. After all, the Fed is unlikely to agree that the net addition of $745 billion to its $3.4 trillion balance sheet since September 2011 was an ill-advised fools' errand. But please note that the Fed is not defining the word "successful" in terms of any particular achievement in the realm of real economy.
Before we discuss that, let's see what the Fed was trying to do.
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In a laudable effort to accelerate the U.S. economic recovery, the Fed thought that large and sustained purchases of long-term Treasury and mortgage debt would hold down the bond yields underlying an entire range of credit costs. That, the Fed expected, would speed up the growth of interest-sensitive components of aggregate demand – household consumption and residential investments, which account for nearly three-quarters of American economy.
The decision to start twisting the yield curve in September 2011 also implied the Fed's conclusion that its virtually zero interest rate policies (in place since December 2008) were not working. Indeed, one now learns that this extraordinary measure was taken because the Fed feared a recessionary relapse of the U.S. economy.
An ill-judged decision
Looking at the evidence, it seems that this was a puzzling error of judgment, because most of the data available at the time the Fed began its "operation twist" could not justify fears of an incipient recession. The gross domestic product (GDP) was growing at an annual rate of 1.7 percent since the spring of 2011, retail sales were growing (in volume terms) at an average annual rate of 3.3 percent in June, July and August of 2011, private consumption was advancing at a rate of 2.6 percent, and the residential investment was rebounding at a rate of nearly 5 percent, marking the beginning of a robust and strengthening upturn of the housing sector.
These numbers are much stronger than the GDP growth of 1.3 percent and private consumption growth of 1.8 percent in the first half of this year. Should one conclude then, using the Fed's own logic, that "operation twist" and asset purchases have been a massive policy failure?
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And here is an even more important question: In view of this dismal result, should the Fed follow last week's advice from the IMF to keep blowing up its balance sheet with continued asset purchases, or should the Fed observe the folksy imperative of the first law of holes -- "when you are in a hole, stop digging?"
The answer is clear. The bond market has led the Fed to its epiphany, whispering that it was an ill-judged decision to try and manipulate the yield curve (the fools' errand if there ever was one).
Here is an example showing the futility of the Fed's attempt to suppress market forces.