Let’s Do the Twist!

The Fed has vowed that it’s ready to act and do whatever it takes to revive the economy, but that doesn’t necessarily mean it’ll trek down QE3 road.

I’ll admit, to a certain extent, the last round of quantitative easing (QE2) did help the U.S. avoid falling into recession. But in no way at all can we say it was a success! If you ask me, QE2 did little besides delaying the problem for another year. Otherwise, the U.S. wouldn’t be in this position AGAIN!

Since it didn’t work so well the last time, the Fed may hesitate buying billions of dollars in securities again. Besides, it wouldn’t be wise to do so with core inflation on the rise. Core inflation rose to 0.5% month-on-month in July, which translates to a 3.6% increase from a year before. Further quantitative easing would only push core inflation higher, and that could spell even more problems for the Fed and American consumers.

Luckily, the Fed has other options on hand to stimulate the economy. A few days ago, in my review on the Jackson Hole symposium, I touched upon some of them. Below, you’ll find two of the most popular choices.

Option 1: Reduce interest rate on excess reserves

Excess reserves refer to the amount of cash that banks hold in excess of the reserve requirement set by the Fed. So how would lowering the interest rate help?

Lowering the interest rate on excess reserves, which currently stands at 0.25%, to near-zero levels would encourage banks to lend. As such, it would place more dough in the hands of businesses and consumers and would help keep money in circulation.

But what are the chances of it actually being implemented?

Well, apparently pretty good, according to Federal Reserve Chairman Ben Bernanke. He has gone on record to say that he and his men are “currently considering” it as an option.

Option 2: Operation Twist

You may think this is some sort of top covert ops mission, but I assure you, it has nothing to do with secret agents and spies (bummer, I know). Operation Twist, which the market believes is just another euphemism for quantitative easing, aims to lower long-term interest rates to further stimulate the economy.

But what makes Operation Twist different from quantitative easing is that the Fed won’t print money out of thin air. Rather, the Fed will first SELL short-term bonds to the market AND THEN use the money it raises to buy longer-term bonds.

Operation Twist, in effect, lengthens the maturity of debts without expanding the U.S. government’s balance sheet.

What will the Fed go with?

Among the two options, Operation Twist seems to be the preferred option. The market widely expects the Fed to announce it after its Federal Open Market Committee meeting two weeks from now.

Still, many market participants (including I), doubt the ability of just one option to bring the economy out of its slump. The threat of recession is still here, and the Fed may end up taking both options, if not a combination of different strategies, to get the job done.

Of course, there’s also the option of not doing anything… but don’t count on that happening! Sitting on its hands is a sure-fire way of dooming the economy to another recession.

“Do something. If it works, do more of it. If it doesn’t, do something else.” -Franklin D. Roosevelt

1 comment

  1. Okmegapips

    I think Mr.Bernanke would go for the combination of the Twist and reducing interest for bank reserve therapies, for the US economy to avoid recession. Since the job market and the sentiments about the economies are still in tatters, the Fed cannot just sit and do nothing.
    The Twist thing sounds very good as far as it does not add to the bourgeoning US sovereign debts. it sounds as if the sales of short term bonds by the fed will make prices low and hence, force up the short term yields while the longer term interest rates would be lower. in a nutshell, they are refinancing.
     

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