By Steven K. Beckner

WASHINGTON (MNI) – It’s back to the well for the Federal Reserve —
but with a twist — “Operation Twist,” that is.

The Fed’s not calling it that, preferring to name it the “maturity
extension program.” But the Fed announced Wednesday it will reprise an
early 1960s effort to drive down long-term interest rates, by selling
shorter term in its portfolio and using the proceeds to buy longer term
securities — to the tune of $400 billion.

What’s more, stepping back into the more recent past, the Fed’s
policymaking Federal Open Market Committee reverted to buying agency and
agency-guaranteed mortgage backed securities instead of replacing them
with Treasuries as they mature.

The former was expected. The latter was not, although MNI has
reported on a number of occasions that it was one option the Fed had in
its toolbox.

Both steps fall short of the more aggressive and controversial step
of resuming so-called “quantitative easing,” i.e. financing the net
purchase of longer term Treasury securities through the creation of new
money or bank reserves to be more exact.

Clearly, the FOMC was not ready for “QE3.” It was hard enough to
get a majority for reinvestment and the latter-day twist.

Instead of buying assets with new money, the Fed will be financing
purchases of longer term Treasuries by selling a similar amount of
shorter term securities in the System Open Market Account (SOMA). It
will sell $400 billion of Treasury securities with remaining maturities
of three years or less and buy $400 billion of Treasuries with remaining
maturities of 6 years to 30 years by the end of next June.

The action “should put downward pressure on longer term interest
rates and help make broader financial conditions more accommodative,”
according to the FOMC announcement released after two days of meetings
Wednesday afternoon.

But that’s not all. The Fed also plans to wade back into the MBS
market, albeit not in net terms.

After halting its purchases of MBS in March 2010, the Fed was
letting MBS roll off, thereby “passively” shrinking its balance sheet.
At its Aug. 10, 2010 meeting, the FOMC began reinvesting principal
payments from agencies and MBS, but reinvesting them in Treasuries. That
had the effect of halting the shrinkage of the Fed’s balance sheet,
while also moving toward the goal of a “Treasuries only” portfolio.

The FOMC reaffirmed its intention to reinvest in Treasuries to keep
the bloated balance sheet from shrinking at its Aug. 9n FOMC meeting.

Now, however, the Fed will reinvest those MBS proceeds back into
MBS, instead of Treasuries while continuing to roll over maturing
Treasuries.

It’s a major departure obviously aimed at further lowering already
low mortgage rates and is sure to have run into opposition from
officials who oppose the Fed getting involved in what they consider
“credit allocation.”

The same three Federal Reserve Bank presidents who dissented at the
Aug. 9, 2011 FOMC meeting — Dallas’ Richard Fisher, Minneapolis’
Narayana Kocherlakota and Philadelphia’s Charles Plosser — voted ‘no’
again. Their opposition was described in general terms: they “did not
support additional policy accommodation at this time.”

When the FOMC approved reinvestment in August of last year it
proved to be a stepping zone for a second round of quantitative easing
(“QE2″). Conceivably, the decision to shift reinvestment into MBS and to
lengthen the average maturity of Treasury holdings will be followed this
year by “QE3.”

Certainly, the FOMC left the door open once again to more monetary
stimulus measures.

“The Committee discussed the range of policy tools available to
promote a stronger economic recovery in a context of price stability,”
it said. “It will continue to assess the economic outlook in light of
incoming information and is prepared to employ its tools as
appropriate.”

First, we’ll have to see what, if anything, the steps agreed upon
Thursday accomplish. But the degree of proven success may not be a major
consideration. Chairman Ben Bernanke and the FOMC majority have shown a
willingness to take chances and try just about anything for which it has
authorization in pursuit of its “dual mandate” for maximum employment
and price stability.

Lately, it is the employment side of that mandate that has been by
far the predominant consideration, as the latest statement makes clear.

“Information received since the Federal Open Market Committee met
in August indicates that economic growth remains slow,” the Sept. 21
FOMC statement says. “Recent indicators point to continuing weakness in
overall labor market conditions, and the unemployment rate remains
elevated.”

As for price stability, the FOMC has few qualms. “Inflation appears
to have moderated since earlier in the year as prices of energy and some
commodities have declined from their peaks,” it says. “Longer-term
inflation expectations have remained stable.”

The statement goes on to say that the FOMC “anticipates that the
unemployment rate will decline only gradually toward levels that the
Committee judges to be consistent with its dual mandate. Moreover, there
are significant downside risks to the economic outlook, including
strains in global financial markets.”

Meanwhile, the FOMC “anticipates that inflation will settle, over
coming quarters, at levels at or below those consistent with the
Committee’s dual mandate as the effects of past energy and other
commodity price increases dissipate further.”

Although the widely anticipated decision to lengthen the average
maturity of the SOMA is being described as “Operation Twist,” the
analogy goes only so far. By contrast to the latter day operation, in
the early 1960s, the Fed and Treasury closely coordinated.

There has been no indication that the Fed and Treasury will be
coordinating this time around. That leaves open the possibility of a
potential conflict.

Were the Treasury to decide to lengthen the average maturity of its
new issues to take advantage of historically low long-term borrowing
rates, that would tend to offset the Fed’s effort to soak up long-term
securities through its own “maturity extension program.”

So far, the Treasury has shown little indication to do more
long-term debt management, however.

More to the point is whether this program becomes the gateway to
“QE3.” It is, after all, the next obvious step if the economy continues
to struggle. There is little else the Fed hasn’t tried, other than
cutting the rate of interest it pays banks on excess reserves (the
IOER), and no one thinks that would have much impact.

** Market News International Washington Bureau: 202-371-2121 **

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