Central Banks Are Rate Followers, Not Rate Setters
On September 21, 2011, Ben Bernanke’s Fed announced Operation Twist. Actually, it was Twist #2 since the Fed had first thought up and executed a program like it all the way back in the 1960’s. The mechanics of a twist are simple enough. As shorter-term UST debt that the Fed already holds comes due, the proceeds are reinvested in replacement securities having a comparatively longer maturity. That’s the twist.
The reason the central bank had come into possession of so many Treasury bonds and bills was quantitative easing, or QE. That sort of program had already been repeated and had been terminated only a few months before.
Policymakers had voted to end QE2 because they believed it had done its job. And yet, mere weeks afterward the FOMC was gathered into another one of those emergency conference calls to discuss how it was the monetary system could be so functionally contradicting of their assessment. The Committee members in early August were even given an option of what would have amounted to bailing out the repo market along the same lines as what we are witnessing today.
Never in a rush to jump back in, it was decided that the Fed would wait it out as long as it could. That lasted all of six weeks. By September 2011, Bernanke knew he had to act. But how?
In one Wall Street Journal article published five days before this particular FOMC meeting, David Wessel argued for the orthodoxy; that so long as unemployment was higher than “normal” and inflation less, “then the central bank should do something—even if no tool seems potent enough to fix the economy.” Taking it logically a step further, the central bank has an obligation maybe a duty to just fake it.
On that last part, officials agreed in private. Talking about the potential choice between implementing something like Operation Twist - its official name at the time was the maturity extension program (MEP) - and a third round of quantitative easing, which is of the type large-scale asset purchase (LSAP), there was a clear consensus in 2011 for the former.
“MS. DUKE. Turning first to the MEP and the LSAP—which I will call by their more popular names, the Twist and QE3—while I doubt that either is potent enough to fix the economy, I do think the risks are manageable. I prefer the Twist, as it is projected to have the same effect as QE3 without further increasing the size of our balance sheet.”
Fed Governor Elizabeth Duke agreed that neither a first MEP nor the next potential LSAP would be “potent enough to fix the economy.”
Once Twist was voted in the affirmative and announced publicly, the Financial Times as one example merely restated, not privy to Governor Duke’s policy assessment, what it had always said about these things:
“The US Federal Reserve launched ‘Operation Twist’ on Wednesday in a bold attempt to drive down long-term interest rates and reinvigorate the faltering economy.”
Was it bold? QE2 had just ended. Reinvigorate a faltering economy? Recently having finished then two rounds of QE, so how could the economy have been questionable?
Two big problems straight away, for sure. Drive down long-term interest rates, though, that’s the big one.
There are always implicit assumptions embedded within conventional wisdom. We believe these things because it seems like we’ve always believed them. If there is any good that will ever come out of central banks playing around with their balance sheets, it is that it will have proved once and for all how so much of what we take for granted is flat out false.
The reason QE is associated with falling interest rates is not just because that’s what central bankers say, it is because there is an intuitive basis behind the idea. A central bank isn’t constrained by anything but the collective imagination (meaning rigid econometric calculations) of the people running it. If they want to buy bonds they can buy all they want.
Being a non-economic buyer, and a potentially big one, it seems reasonable that the prices of whatever bonds falling under their suspicion would be greatly affected by the activity. Simple, small “e” economics says that all else being equal additional demand for something drives up its price. When talking about bonds, that means interest rates fall.
Thus, in terms of MEP (Twist) versus LSAP (QE3), if the goal is strictly to drive down long-term interest rates then the effects of the two would be indistinguishable. The costs would be different, since the second would require a larger overall balance sheet whereas the first keeps everything at the same level (Twist is a remix of ultimately the same quantity of assets).
For these reasons, Operation Twist was preferred hands down.
There was only one, Richard Fisher of the Dallas Fed, who dared point out the invalidity of the several assumptions at work here. The primary issue wasn’t the size of the Fed’s balance sheet, which is what policymakers thought, rather it was the more basic condition of interest rates themselves.
“MR. FISHER. In summary, I want to mention that, as I said earlier, most of these variations that have been suggested are very un-Bagehot-like. And what I mean by that is, twisting entails purchasing assets that investors are fleeing toward, not assets that they are fleeing from.”
To put it another way, why are policymakers so hellbent on lowering long-term interest rates that had already been reduced by the market? Not by a little, either.
On February 8, 2011, the 10-year US Treasury yield stood at a recent high of 3.75%. It had fallen during the middle of 2010 and then rebounded sharply after the Fed had confirmed a second round of bond buying (also contrary to how it’s supposed to work).
As it became clear (to the bond and money markets) there would be more of this second global dollar shortage in the months (and years) ahead, the 10-year yield sunk. On September 22, the day following the Twist announcement, the benchmark rate closed at 1.72%. Driving down long-term interest rates, the market had been doing what the Fed would much later like to describe as “bold” “stimulus.”
Remarkably, from September 23 forward, while the FOMC was now reinvesting and buying at the long end, long end rates rose. By the end of October, the 10-year yield was as high as 2.42%. It would meander around the 2% mark before one last jump higher (not lower) in mid-March 2012.
All during Operation Twist.
It wasn’t until April 2012 that long-term rates would decline again – though still not for reasons of bond buying.
This second leg down in yields was much the same as the first; growing concerns about the economic consequences of an unchecked monetary problem. When these first arose, re-arose, in early 2011, central bankers took nothing from it, remaining detached and disinterested.
Ben Bernanke’s Fed ended QE2 indicating how comfortable US authorities were with letting it all play out. Jean-Claude Trichet’s ECB took it a step further, raising rates (twice) during and despite the bond market’s shouted warning (it had driven down long-term rates in Europe, too).
This was the crisis template: bad things start to happen, officials ignore and downplay them until they get to a point they can no longer be ignored or dismissed as trivial. Then central banks altogether act in “bold” ways that do what? Drive down the long-term interest rate that’s already been driven down?
That’s ultimately what leads to the second leg lower in yields. The first is the problem showing up, the second is the market exhausting its patience. The bond market actually gives these people a chance to figure it all out; that’s why yields backed up in September 2011 and stayed relatively steady over the next six months.
During that half-year period, bond yields were amazingly constant. Despite a whole lot going on (to both sides) bonds stuck to the sidelines. On the one hand, dollar shortage and the global economic implications of them. On the other, not bond buying specifically but the possibility bond buying might be the first step in central bankers waking up.
In other words, traders (meaning banks) in the Treasury like the bund market turn from pessimistic (their bond buying is what drives down long-term yields) to neutral once monetary authorities are alerted. But what traders really want to see is not the next QE, Twist, or some other really similar bond buying approach, they are wondering if maybe officials will actually do something truly bold meaning materially, categorically different.
I mean, after all, even FOMC officials in September 2011 knew how more of these balance sheet games wasn’t going to do much for the economy. Bonds simply waited to see if that realization would then lead to some epiphany when Bernanke’s people might start to really connect the dots for once.
It wasn’t a good chance, the reason why yields remained in a narrow, low nominal range.
Operation Twist was augmented by several further actions around the world, but these, too, were just repeats. Later in 2011, the Fed reopened dollar swap lines and even reduced the cost charged for using them. The ECB reduced rates back to zero, drastically loosened collateral requirements at its funding windows, and then embarked on a “bold” LTRO program (actually two) which was widely applauded by Economists and the financial media but curiously not the bond market.
Bold central bank action notwithstanding, these things come with an expiration. A pretty simple one, too. Either the economy responds favorably, it actually improves in reality and not just fevered mainstream narrative imagination, or Phase 2 of the yield plunge.
The other side of this is that narrative, how no matter what a central bank does or how the economy really performs, the latter is always described as improving in the aftermath of the former doing something, anything.
One big reason why is long-term yields. The media pays little attention to them until directed to by whichever central bank program focuses commentary back in their direction. They are then confused one for the other; bond buying programs are said to have been effective because at the very least look at how low interest rates are!
What follows is confusion. Rates have fallen and that’s supposed to be a good thing. That they’ve fallen must be central banks finding early success with their boldness. How could things not be improving?
It’s a possibility that academic Economists and monetary authorities rarely contemplate. But they do from time to time. One of those times was just a few years before during the latter stages of the pre-crisis era, an academic paper put out by the St. Louis branch of the Federal Reserve that asked the question while being palpably terrified by the (correct) answer.
“The possibility that domestic real long-term interest rates are segmented from domestic short-term rates has strong implications for perhaps the most widely held theory of the monetary policy transmission mechanism—the interest rate channel of monetary policy… If long-term real interest rates are determined in a global market, the FOMC’s scope for affecting domestic real long-term yields by adjusting its target for the federal funds rate may be limited.”
While the Fed’s main lever of monetary policy in the pre-crisis era had been the fed funds rate, applying this “conundrum” to the post-crisis it becomes one for MEP’s, LSAP’s, maybe even not-QE’s and the repo interventions (that don’t intervene in the repo market) of 2019-20.
As the St. Louis paper pointed out, the interest rate channel has been the most widely held theory of monetary policy transmission. It’s the very thing that the financial media writes about. As Alan Greenspan said around the same time, long-term rates are, to those like him, nothing more than a series of one-year forwards. An array of theoretical instruments that all trace back to that first one which the FOMC moves at will.
It is an assumption, the Fed controls interest rates.
If people didn’t think much about it before 2008, they ponder it even less after all the QE’s. And that’s a huge problem. Experience as well as all the empirical evidence shows the theory is all wrong. Dick Fisher was right – the Fed ends up buying only what assets are already in high demand. Long-term interest rates are driven, one way or the other, in a global market independent of all central banks.
In March and April 2012 this meant only one thing. It didn’t matter that Operation Twist was still ongoing. What did matter was that it hadn’t worked, nor had the ECB’s LTRO’s. The fears which drove bond yields lower in 2011 finally materialized around those months in 2012. Europe would, in fact, fall into recession while the US economy would come awfully close over the course of the rest of the year.
Asia and the rest of the world haven’t been the same since.
And despite the official preference not to expand the Fed’s balance sheet, that’s just what they did in September 2012 (QE3) and again in December (QE4). Why?
To emphatically drive down long-term interest rates! Which, by then, had already fallen to record lows as determined by a realistically pessimistic global bond market.
Bond yields in 2019 were driven to new lows in many places and near new lows in others like the Treasury market (though the 30-year did reach one). Cause and effect have been reversed in the public’s collective imagination through the one thing the modern central bank does well: messaging and PR.
The Fed doesn’t drive bond yields lower no matter what it buys. The bond buying starts after the yields have already fallen; for once in his career Dick Fisher managed to get that right. The same thing that pushes interest rates downward is what eventually gets policymakers’ attention.
It’s not “stimulus”; it is a reaction which is why what inevitably follows in economic terms is not an economic turnaround supported by the downward direction of the bond market as stated as fact in every news article. The world just doesn’t work that way, which is what everything over the last decade plus has shown.
And yet, the debate still rages in 2020 as to what is or is not QE. What we can take away from 2011-12 and the presumed differences between MEP and LSAP’s is that there really are none. Balance sheet tinkering in any form is neither proactive nor helpful in any identifiable way outside of news articles. It certainly isn’t bold.