Here we go again. Our hyperactive Fed has announced Operation Twist. It is a repeat of 1961 where the Fed tried without much success to flatten the yield curve by buying long term bonds while selling short term bills. In those days one of the purposes was to lower the cost of the government debt. Today the Fed is supposed to be trying to lower long term rates in order (it is said) to push mortgage rates even lower in an effort to boost housing. I find this hard to believe. Mortgage rates are already extremely low and the housing market is essentially flat. Until consumer sentiment turns up and the economy recovers, housing will still stagnate. Personally I think that the Fed feels obligated to seem like it is trying to do something and I seriously doubt if even Bernanke is confident that this Operation Twist will do any good. The reality is that the Fed once it committed itself to aggressive discretionary policy finds that it must keep easing or else market forces will cause rates to rise. I learned this in graduate school in the 1960s and it is still true today. Consider that the Fed has injected over $1 trillion in liquidity into the banking system. That money has piled up in excess reserves. Given the paucity of consumer demand for borrowing, the banks can earn interest just by leaving it in reserves without incurring additional risk. Bankers have told me that their regulators - ironically including the Fed - have hammered them on their lending decisions and have nitpicked their loans actually discouraging them from lending. Now the banks can borrow at virtually zero interest and lend the money back to the Fed. What Bernanke is doing is making the fundamental mistake in thinking that interest rates are the major determinant of lending and borrowing decisions. It is not. Borrowers will borrow at higher rates if demand is high enough to be profitable and will not borrow at low rates if there is little demand for the final products. The Fed should know this. When the recession started I wrote that the best Fed policy was to do nothing. The same is true today. We are ion this mess largely due to misguided monetary policy. Just like the country needs another Ronald Reagan, the Fed needs another Paul Volcker.
Harold A. Black is professor emeritus in the Department of Finance, University of Tennessee, Knoxville having retired after 24 years of service. He has served on the faculties of American University, Howard University, the University of North Carolina - Chapel Hill and the University of Florida. His government service includes the Office of the Comptroller of the Currency and as a Board Member of the National Credit Union Administration. He also has served on the boards of directors Home Savings of America and its parent company, H. F. Ahmanson & Co., Irwindale, California prior to its merger with Washington Mutual Savings Bank, on the board of New Century Financial Corporation, Irvine, California, then the nation’s largest real estate investment trust and as director and later chairman of the Nashville Branch of the Federal Reserve Bank of Atlanta. He writes an occasional article for the Knoxville News-Sentinel at http://www.knoxnews.com/staff/dr-harold-black/. His web page is haroldablackphd.com