Posts Tagged ‘Operation Twist’

Uncle Ben’s Reverted Price

Thursday, April 19th, 2012

The price of financing the U.S. debt is the interest paid to America’s creditors, but to whom does America pay that interest? Who owns the biggest slice of the U.S. debt? If you’re thinking China or Japan, those trade deficit bogeymen of the East, you’d be wrong and by quite some distance: those relative pikers are in a close battle for second, with the PRC slightly edging out Nippon but each holding about a trillion dollars worth, good for 7% apiece. The reigning champ out-distances both by 70%, holding $1.7 trillion dollars or nearly 12% of America’s $14.28 trillion national debt. Fortunately for Uncle Sam, however, that top lender is like no other, for this is a creditor from whom all interest paid on the debt it holds is “reverted” straight back to the borrower, which is to say the U.S. Treasury. I refer, of course, to the Federal Reserve.

With the Fed funds rate hovering near zero, the Fed resorted to massive Treasury purchases in an effort to drive down interest rates and stimulate the economy, a policy which has made the central bank Washington’s largest creditor. Because all Fed profits are rebated back to the Treasury, the interest on the 12% of U.S. debt held by the Fed is being returned directly to the Federal government’s coffers and, by extension, to American taxpayers, since every dollar of interest the Treasury receives back from the Fed is a dollar it does not have to collect from taxpayers in order to finance the debt. Given that 20% of tax revenue goes to servicing this debt, that’s quite a break we’re receiving from Bernanke & Company.

Yet it gets better. Like disk jockeys programming an oldies station, the FOMC’s members recently brought back a blast from the past, the 1961 monetary policy sensation known as “Operation Twist.” In the September 2011 remix of this interest rate two-step, the Fed announced it would sell $400 billion of Treasuries with maturities of no more than three years, using the proceeds to purchase an equal amount of 6- to 30-year T-bonds. Given how low short rates already are, the idea is to lower rates at the long end of the yield curve by pushing out the maturity of the central bank’s holdings and taking longer-dated T-bonds out of the market. The theoretical argument is that lowering the long rates should stimulate the economy, while the counter-balancing short-maturity sales hold the size of the Fed’s balance sheet constant. A side effect of this kind of maneuver is that, as it skews the Fed’s holdings toward higher-yielding long Treasuries, the fraction of total interest on U.S. debt rebated to the Treasury by the Fed will increase even though the value of the Fed’s Treasury holdings are held constant. As an added bonus, those lower long-term rates mean reduced long term costs of further borrowing by the Treasury as it finances that ever-increasing U.S. debt.

All this may sound suspiciously like the free lunch your economics professors told you was but a culinary myth. But the tab’s arrival may be delayed while markets extract a higher price for the fiscal over-consumption of other nations. The Fed’s epic Treasury purchases are funded by money the central bank creates and injects into the markets, which, ceteris paribus, might be expected to depress the value of the dollar and increase inflation. However, ceteris hasn’t been particularly paribus lately; ongoing Euro-antics continue to place a safe haven premium on both the currency and debt of the United States (see “Send Treasury Your Retired, Your Not-So-Poor, Your Befuddled Classes Yearning To Invest Risk-Free…”) while, in the wake of the financial crisis, sluggish global growth has restrained increases in both labor and commodity costs. This trend has been reinforced of late by recent slowdowns in China and India, engineered by those countries’ central banks in the hopes of restraining their own domestic price pressures.

Nevertheless, the nascent recovery in the U.S. has been attended by a run-up in the price of oil and, recently, rising unit labor costs, causing the TIP spread between regular and and inflation-protected Treasury bonds to widen, albeit modestly. If, as some recent data from Beijing indicate, China’s landing proves to be more of a brief layover, and should concern over a full-blown Euro implosion continue its recent ebbing, then the U.S. may learn a truth diners at complimentary buffets generally discover: sooner or later, gorging on a seemingly free lunch is paid for with inflation, be it in your waistline or your currency. But for a Fed faced with the alternative of stalled growth, increased inflation risk may be, as the old saying goes, just the price of rice, converted or not.