Probably fewer than one person in a hundred in our fair land actually knows what the Fed is doing with its “Operation Twist” strategy, so we will try to explain it — because there’s something going on here that we think you really ought to know about: how the Fed is doing its level best to bolster Obama’s election chances by taking a sizable risk with your money that will very likely backfire.
The “twist” stategy couldn’t be simpler. The Fed sells one year notes to bond buyers at the same time it buys ten year bonds from the bond market. The money supply does not expand, because the amounts offset each other. Selling the short-term notes creates additional supply, so their price falls, and the short-term interest rate rises. Buying long-term bonds increases their demand, so their price rises, and their rate falls. The idea behind the “twist” is to stimulate the economy and provide job growth by lowering long-term interest rates. This, theoretically, assures businesses of cheaper long-term credit, and therefore makes them more willing to expand and hire.
Because there is no pumping of additional funds into the money supply, the “twist” is not inflationary — unless it is. How?
A long-standing law of banking is that a bank should never finance long term lending by short term borrowing. If it does, it runs the risk of paying more in interest than it earns over the life of the loan if short term interest rates rise. This is a good way for a bank to go bust.
Well, guess what? The Fed is a bank. And “lending long, borrowing short” is exactly what it is doing. Unlike other banks (usually), the Fed can’t go broke. But it can lose a lot of money — and that’s your money, by the way. And here’s the particularly cruel wrinkle to this particular twist:
US interest rates are at their lowest level since the 1940s, and well below rates since 1960.
It is very unlikely that they will stay at this level for another ten years, or, if more pessimistic projections are heeded, even for much longer at all. The greater the rise in rates, the more money the Fed loses. There are only two ways to recover these losses — either by raising taxes, which is unlikely, or by printing new money, which has always been the option of choice, and is exactly what the “twist” is meant to avoid.
But why do interest rates rise? Generally because infation has increased. Pumping yet more cash into an already bloated money supply has the same effect on inflation as pumping steroids into a bully. And more gruesome still — the more inflation rises, the higher the interest rates go, and so on and so on.
Our friend the Maverick, with his usual good humor, comments that “it’s strange that nobody is really focused on this one. We are only a short breath away from the turn in rates and then there will be hell to pay.” And pay we will.
But hey, as long as it helps re-elect the President, I guess the cost is within reason. After all, it’s your money.