The Federal Reserve’s latest plan to prop up the sagging American economy, known as Operation Twist, won’t have a significant impact, says a finance expert at Washington University in St. Louis.
“The problem with the economy currently is not that long-term rates are too high,” says Radhakrishnan Gopalan, PhD, assistant professor of finance at Olin Business School.
“The problem is uncertainty and lack of demand, both domestic and export. So a few basis points fall in long-term rates may not have a big impact,” he says.
Operation Twist calls for the Fed to shuffle $400 billion of its portfolio from short-term bonds to long-term in an effort to keep long-term interest rates low. By July 2012, the Fed will buy Treasury bonds with maturities from six years to 30 years, while selling an equivalent amount of Treasuries with maturities of less than three years over that span.
“The fact is, no one is complaining that long-term interest rates are too high and hence they are not investing,” Gopalan says. “People are not investing because of heightened uncertainty.”
Gopalan says there is a slight uptick in the amount of long-term debt firms are raising.
“Firms with good credit rating are beginning to borrow long-term, trying to take advantage of these low rates,” he says.
“Unfortunately, they are raising the money but not investing it in the U.S. They are either keeping it as cash for a rainy day or investing it elsewhere. They don’t seem to be spending all that money and it isn’t leading to greater growth.”
Gopalan says there were a few surprises in the Fed’s announcement.
“The stock market was pricing in about $300 billion of Operation Twist. But Ben Bernanke (chairman of the Federal Reserve) announced a $400 billion plan, larger than the initial expectation,” he says.
The market also was not expecting Bernanke to announce that the Fed is going to continue investing in mortgage-backed securities, Gopalan says.
“The Fed has a portfolio of mortgage-backed securities that are maturing,” he says. “Basically, they are getting paid in cash. The Fed has been using this cash inflow to invest in treasury securities. Bernanke announced they will now use the cash to buy mortgage-backed securities.
“This was in response to the fact that the mortgage rates are not coming down sufficiently. The spread between Treasuries and mortgage rates is high. The low interest rates in the Treasuries have not transferred to the mortgage markets.”