What's the Fed up To?

Given the bad economic news of late, many eyes have turned to the Fed as it seems to be the only institution left with the ability to act. Central Banks the world over have been stepping in: The Bank of England started a new round of Quantitative Easing[1], the European Central Bank, the Bank of Korea, the Central Bank of Brazil, and of China have lowered their target interest rates to ease lending[2]. 

Though it has not made big news, the Fed did recently act by embarking on a second installment of “Operation Twist” (OT). OT is a process where the Fed tries to twist the yield curve for government bonds to push down long term interest rates and push up short term interest rates (see out of date graph below). The Fed does this by selling its short term bonds and buying long term bonds, in this way the action puts no upward pressure on inflation. Basically, when one buys a bond they are purchasing the future stream of interest payments that bond will generate should the borrower not default, therefore, the higher the bond price the lower the real interest rate. Reducing long term interest rates is the more important goal because it will stimulate (in theory) capital investment and housing demand.

But this additional action is more appearance that substance. The effectiveness of the practice in general is still highly debatable. The law of diminishing returns holds that each additional bond sold and bought by the Fed will have less and less of an effect, another round of OT will thus be less effective than the first (which hasn’t exactly fixed the economy). The Feds stock of short term bonds is not infinite and it would be very unwise to sell them all and reduce the diversity of bonds held. According to Macroeconomic Advisers (a consultancy I enjoy referencing), as the Fed sells off its short term bonds it will eventually need to sell off short term bonds of a longer maturity, decreasing its effectiveness further.

So why do it? The Fed has constantly been saying that if the economy slowed further it would take stimulative action. In fact they just yesterday teased at this prospect again. Given their statements, and the poor state of the economy when the first round of OT ended, doing nothing more would have the appearance of withdrawing stimulus. Put simply, the Fed has acted to keep people from noticing that it has not really acted. 

That being said I think the Fed is a great institution. If only other institutions, such as the FDA and EPA were as politically independent with as clear a mandate. 




1. Quantitative Easing is when the central bank buys financial assets from banks with money that the central bank "created" by adding it to their computers. It's printing money for the 21st century.

2. To be fair, England is already in a recession again, the interest rate targets for the Euro Area and Korea are higher than the target for the Fed even after their recent adjustments, and comparisons cannot be so easily made across developing and developed countries.