Fed May 'Twist' Balance Sheet to Promote Recovery

With divided leadership, the Fed has few tools left to stimulate the economy.

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With dwindling policy options at its disposal, the Federal Reserve will continue to do what it can to stimulate the economy...which is to say not much.

The Federal Open Market Committee, which oversees the Fed's buying and selling of Treasury securities, will have an extended, two-day meeting later this month to discuss potential policy moves. One policy the committee will almost certainly consider will be a "twist"—that is, a shift in the Fed's balance sheet, involving the sale of short-term Treasury bonds to facilitate the purchase of longer-term bonds. According to the minutes from the committee's August 9 meeting, some members advocate this strategy as a way to lower longer-term interest rates.

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But in the current economic environment, it is unclear what—if any—beneficial effect such a policy might have. Mark Luschini, chief investment strategist at investment advisory firm Janney Montgomery Scott, believes that a twist's effect would be "marginal." He explains, "were interest rates ... an impediment to demand in the economy, then lowering interest rates would certainly be helpful."

However, interest rates are already at historic lows. The yield on 10-year Treasury bonds recently hit a record low, meaning that many businesses and homeowners are seeing remarkably low borrowing costs. But U.S. corporations, fearing further uncertainty, are sitting on massive amounts of cash and have no need to borrow. Standard & Poor's reported last month that non-financial companies in the S&P 500 have over $1 trillion dollars in their reserves. Likewise, the Mortgage Bankers Association this week reported that demand for U.S. home loans continues to drop, despite 30-year fixed mortgage rates inching closer to 4 percent.

John Lekas, president of investment advisory firm Leader Capital, goes further than Luschini, believing that only the free market, and not Fed policy, can help the economy recover at this point. A twist, he says, would be a "nonevent." "They've gotten as much as they can out of their QE1 and QE2," he says, referring to the first and second rounds of the Fed's quantitative easing programs. "In other words, it doesn't matter what the Fed is doing."

Additionally, while less attractive bonds might theoretically drive would-be buyers to the stock market, says Luschini, low rates on Treasury bonds have already driven most investors away. "It's hard to imagine that bonds could look less attractive than they already do," he says. "Clearly at this juncture, I don't think investors are buying bonds for the yield as much as they are store of value."

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But the Fed is finding itself with few good policy avenues to stimulate the economy. The Open Market Committee has been notably divided in recent months over the prospect of further loosening monetary policy. Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, in August posted a video on that bank's website explaining his dissent toward the Fed's recent indication that it would hold the federal funds rate between zero and 0.25 percent through mid-2013, noting recent inflation. Meanwhile, Chicago Fed President Charles Evans has indicated an openness to further easing, saying that the bank should "seriously consider actions that would add very significant amounts of policy accommodation," even if it means a temporary bump in inflation.

With the committee sharply divided over significant monetary loosening, the Fed has few options left to it which could make a big difference. Aside from a twist, the Fed might also lower the interest rate on banks' excess reserves. Doing so would make it less attractive for banks to hold onto that money and more attractive to lend it. But as with a twist, widespread economic uncertainty could minimize the effects of a decrease in this interest rate. "I don't think it's just banks being unwilling to lend as much as it is borrowers really suppressing the demand for debt because they're uncertain about how things look for business or their personal situations," says Luschini.