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How does Operation Twist differ from QE?

In a direct sense, almost none at all. Despite the common perception that “Operation Twist” is an ineffectual, conservative move, while further quantitative easing would be a powerful and risky one, the fundamental economic difference between them is quite minor.

But maybe perception itself is the problem.

In its press release two weeks ago, the Fed pledged to:

…purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less.

Is this different from quantitative easing? QE2 was equivalent to the combination of two open market operations:

  • (1) Buying short-term Treasuries with newly created money.
  • (2) Swapping short-term Treasuries for longer-maturity ones.

The Fed’s new policy is just operation (2), disconnected from (1). Operation Twist is less effective than a potential QE3, therefore, to precisely the extent that operation (1) makes a difference.

Does it? First, let’s be even more precise, breaking down (1) into two smaller components:

  • (1A) Buying T-bills (extremely short term Treasuries with duration less than a year) with newly created money.
  • (1B) Swapping T-bills for a broader mix of short-term Treasuries (e.g. those with remaining maturity “3 years or less”).
  • (2) Swapping short-term Treasuries for longer-maturity ones.

Virtually everyone agrees that (1A) is useless: yields on 1-year T-bills hover around 0.1%, which is almost exactly the same as the effective federal funds rate. Yields on shorter T-bills are even lower. For all practical purposes, T-bills and reserves are equivalent assets—they’re both extremely liquid and offer a safe nominal return. Exchanging them does nothing.

If there’s a difference between Operation Twist and QE, then, it really has to be in (1B). This is already a little amusing: all the rhetoric contrasting Twist and QE, if it has any logical interpretation, boils down to an extremely specific statement about the effects of a particular maturity swap. (I’m pretty sure this is not what everybody is thinking!)

Of course, it’s conceptually possible that (1B) matters. Maybe reserves and T-bills do have some special “moneyness” (e.g. liquidity value) that 1-3 year Treasuries do not, and by expanding the relative supply of this moneyness we can make it less valuable—thereby pushing down yields on the securities that lack it. But this is easy to check: let’s just look up the difference in yields! This will tell us the maximum possible effect of the policy.

The yields on 2 and 3-year Treasuries are currently 0.25% and 0.42%, respectively. Needless to say, these aren’t much different from the current 0.1% yield on reserves and 1-year T-bills. But that actually isn’t the right comparison—we should be looking at the rates on 2 or 3-year debt versus the rate expected on reserves/T-bills over the next 2 or 3 years. This will tell us whether slightly longer-term securities are trading at a discount because they lack the features of money. As it turns out, the average rate over the next two years on the Fed Futures market is 0.15%, while the average rate over the next three years (assuming Sep. 2014, which is missing, is the same as Aug. 2014) is 0.32%.

In both cases, the Treasury yields are 0.1% higher than the corresponding average of forward rates. This is the gap that (1B) might address. It’s not zero, but it’s incredibly small relative to the other possible impacts of the policy, like the impact on long rates (even a 0.1% decrease in yield on the 10-year would be vastly more important, since it implies a much larger increase in price than the same change on a 2-year), or signaling.

To sum up: the fundamental difference between Operation Twist and QE, which boils down to the effect of a very specific asset swap, is extraordinarily minor.

Of course, most people disagree with this analysis—they think, for whatever reason, that QE is much stronger stuff. As I’ve explained, this doesn’t make sense from a fundamental perspective, but nevertheless it may be partly self-fulfilling. After all, perceptions matter.

This is possible even if you assume market participants themselves are rational and understand monetary policy. Consider the following simple model of the Federal Reserve: it wants to make monetary policy easier, but it’s constrained by political pressure from the Rick Perrys of the world and internal pressure from the Richard Fishers. Its decision to try Operation Twist, a mostly equivalent but marginally less effective alternative to QE, is a signal that it’s bowing to pressure from politicians and FOMC hawks, who irrationally think that QE is much more dangerous. While the true effect of replacing QE with Twist is minor, this signal about the Fed’s decision process has serious implications for how policy will be set in the future, and that’s extremely important.

Alternatively, maybe 20% of the market doesn’t understand monetary policy and thinks that QE will be wildly inflationary. Here we hit upon a quirk of monetary policy: expectations of inflation can be partly self-fulfilling, especially at the zero lower bound (where the Fed doesn’t move to counteract them). That 20% will purchase more (after all, their savings are about to be inflated away!), write contracts that embed inflation, hike prices, and so on. This leads to a little more inflation. Anticipating this, the other 80% adjusts its inflation expectations upward. This will lead to even more inflation. Anticipating this, the rational 80% adjusts expectations even more, and so on. Bottom line: under conditions of strategic complementarity, which many economists believe apply to price-setting, a small population with irrational beliefs can make a big difference.

Both these effects probably play a role. And that’s why, even though economics tells us that Twist is essentially the same as QE, it may ultimately have far less of an impact—precisely because so many people think it’s less potent.

(Yes, it’s frustrating to be an economist sometimes.)

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