To Twist Or Not To Twist, That Is The Question

The FOMC (Federal Open Market Committee) has kept rates at the zero lower bound once again on March 17, pointing to the slackness in the economic recovery and slightly deteriorating labor market conditions.

Despite giving an assurance that the accommodative monetary policy stance will be sustained until substantial progress has been made, the FOMC has made a mistake by not directly addressing rising long-term yields via maturity extension program.

Here is why: Maturity extension, also known as “Operation Twist”, is a policy tool whereby the Fed directs the Desk at Federal Reserve Bank of New York to purchase long-term treasury securities, primarily 10 year and 30 year treasuries, and simultaneously sell short-term treasury bills and treasury notes up to 3 years of maturity.

The primary goal is to push down long-term interest rates.

Since long-term treasury yields heavily influence long-term borrowing rates for households and businesses, they are a reflection of what is happening in the credit market.

With the anticipation of a quick economic recovery around this year, market participants have started bidding up the yield on 10 year and 30 year treasuries, whose yields mainly track the expected path of the Fed’s policy interest rate- Federal Funds Rate. In addition, the term premia on these securities also began to rise, causing yields to go up even further.

This lead to a pre-mature tightening in financial conditions as mortgage borrowers and highly-rated corporations are now facing higher interest rates.

The Mortgage Bankers Association Purchase Index, which is an index for the single-family mortgage loan applications, has declined
considerably starting from the beginning of February as a result of rising interest burden.

Given that the housing market comprises a significant portion of American households' wealth, a slow- down caused by rising borrowing costs should not be welcomed. The Fed’s purchases of mortgage-backed securities narrows the spread between these securities and treasury securities of the same maturity, and lowers mortgage rates. However, this effect is offset as treasury yields make their way higher each week.

On the other hand, American corporations have the highest level of corporate debt in America’s entire economic history; as a matter of fact, the US economy cannot withstand an interest rate shock at such an overleveraged state.

Having missed its core PCE (personal consumption expenditures) inflation target of 2% consistently except in 2011 and 2018 after the Great Recession, the Fed decided to adopt Average Inflation Targeting (AIT) regime on September 2020.

The goal is to allow for more flexibility in monetary policy decisions in order to achieve maximum sustainable employment and price stability.

In the last press conference, Chairman Jerome Powell accentuated his dovish policy stance by stating that this year’s overshooting inflation rate won’t count towards the assessment of the average inflation targeting regime; in addition, FOMC’s latest SEP (summary of economic projections) indicates that the median estimate for the Fed Funds Rate for 2023 is still at 0.1% even though the median unemployment rate estimates for 2022 and 2023 are below the Fed’s estimate of full employment which currently stands at 4%. In both examples, the Fed shows that it is dedicated to adhering to its new regime and to accommodative policy stance, but the market participants don’t find the Fed’s actions to be credible, nevertheless.

The bond market continues to price in higher yields for longer term treasuries, which it had already been doing before the
last meeting.

Had the Fed addressed this issue by implementing maturity extension, it could have had the opportunity to substantiate the credibility of its policy decisions which would have consequently pushed down the treasury yields and thus the economy-wide borrowing costs.

That Chairman Powell did not hint at how the Fed would handle rising yields when answering a question about treasury yields at the press conference has also given off an unconfident impression to the markets.

In summary, I believe that maturity extension is still in the toolbox of the Fed for the next FOMC meeting on April as the economy is far from its pre-pandemic level with 10 million jobs having been lost and the path of the pandemic highly uncertain.

The Fed shouldn’t allow long- term interest rates to rise above its estimate of the natural rate of interest at which the economy

grows in tandem with the potential growth of output with no output gap and inflation stays at the 2% target level.
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