Gavyn Davies did an item yesterday featuring a cute conceit that I think is very helpful to understanding what the Fed did and didn’t do yesterday. The way he put it is that two different ideas were under consideration, “Operation Twist” and “Operation Shout.” Operation Shout would have been the kind of thing that Chicago Federal Reserve President Charlie Evans has been pushing for, change the statement to say that the FOMC is prepared to tolerate additional inflation until unemployment falls below 7 percent. Operation Twist is an effort to alter the convexity of the bond yield curve. In other words, interest rates on long-term debt are almost always higher than rates on short-term debt, but the Fed can swap securities to influence the extent to which that’s the case.
What we got from the FOMC was the twist rather than the shout. In models where monetary policy acts primarily by shaping expectations, shout is a lot more important than twist.
By contrast, in models where monetary policy operates primarily through the channel of interest rates twist does more than shout. The problem with this theory (aside from it being wrong) is that the very same models that see the interest rate channels as critical are the models that suggest monetary policy can’t boost the economy with short-term rates near zero. When you hear people complain about “pushing on a string” this is precisely the scenario they have in mind. The FOMC is going to make it cheaper for people to make long-term fixed investments but they can’t actually force anyone to do it. And, indeed, insofar as you were complacent about inflation last week but worried that potential customers won’t have jobs nothing about this action suggests you should be less worried.
So for this to work, something has to happen at the other end of the string. One possibility would be massive fiscal stimulus, which could be done any time Congress feels like it but won’t happen. The other possibility is mortgage refinancing. With long-term rates lower, households may refinance mortgages thereby increasing their disposable income. In other words twist + refinancing can serve as a kind of helicopter drop. But for this to work something else probably needs to happen — Fannie Mae and Freddie Mac need to take some kind of action to support large-scale refinancing of the huge array of mortgages they own. Whether or not to do this has been stuck in some kind of bureaucratic black hole for a long time now, and I have no idea what the prospects are for getting out.