Wednesday, September 21, 2011

Operation Twist and Treasury Debt Management

As expected, the FOMC announced today that it will lengthen the maturity of its portfolio holdings of Treasury securities in an attempt to lower long-term interest rates.  No one is sure whether this will work.

One question that naturally arises is whether the Treasury Department will alter its debt management policy.  Under the current Administration, the Treasury has been lengthening the average maturity of the debt held by the public (which includes Federal Reserve Bank holdings).  Will Treasury continue that policy?  Probably the answer is yes, but, at the same time, Treasury will probably not make things more difficult for the Fed by taking advantage of its new initiative by selling more long-term debt than it would have otherwise.  The Financial Times published an article about this last week, misleadingly headlined “Treasury to accommodate Fed on ‘Twist.’”  In fact, the article only states that “the Treasury would be unlikely to respond to falling long-term interest rates with a sudden shift in the pattern of debt issuance, even though one of the Treasury’s strategic goals is to increase the average term of the US national debt.”  The article does not state that the Treasury would try to shorten the average maturity of the debt.

As for the original Operation Twist in the 1960s, one little remarked fact is that during this program, which was a joint Treasury/Fed initiative, the average maturity of the public debt increased from 1960 to 1963 (fiscal years). (See the table from the 1968 Report of the Secretary of the Treasury on page 74.)   In a short history of U.S. monetary policy posted on the New York Fed’s website, Treasury’s contribution is summarized as follows: “For a few months, the Treasury engaged in maturity exchanges with trust accounts and concentrated its cash offerings in shorter maturities.”  As for the Federal Reserve, it “participated with some reluctance and skepticism, but it did not see any great danger in experimenting with the new procedure.  It attempted to flatten the yield curve by purchasing Treasury notes and bonds while selling short-term Treasury securities.” (See page 39 of this document.)
While there have been some attempts to quantify the effect of the original Operation Twist, not much can be inferred from this experience, since Treasury’s contribution was minimal and eventually at cross purposes with the program.  Also, as Modigliani and Sutch in their much referenced article on Operation Twist point out, to the extent that there was a change in the term structure, the reason for this may have been attributable to increases in the interest rates that could be paid on time deposits at banks under the Federal Reserve’s Regulation Q which led to the creation of certificates of deposit (Franco Modigliani and Richard Sutch, “Innovations in Interest Rate Policy,” The American Economic Review, Vol. 56, March 1966, pp. 178-197.)  The effect on the yield curve of altering the supply of Treasury securities at various maturities is an unanswered question.  Assuming the Treasury does not undermine the Fed by its debt management decisions, the Fed is embarking on an experiment which will provide more data for those wishing to study this question.

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