Let's twist again

What does the Fed hope to achieve with its latest piece of monetary policy wizardry, the so-called "Operation Twist"? Over the next nine months, the Fed will be selling some of its holdings of short-term government debt while buying more long dated securities -- up to $400 billion's worth. The goal is to flatten or "twist" the yield curve. Not attempted since 1961, the scheme is basically a prolonged version of the Fed's regular liquidity management operations, the familiar but oddly-named "coupon pass".

The Fed's hope is that lower long-term rates will persuade businesses to invest more, pulling the US economy out of its deepening funk. The problem with this is that the US corporate sector as a whole is already awash with cash. Companies are not failing to invest because they can't find funding; they're failing to invest because of a profound lack of confidence in the future. If the plunge in global stock markets since the Fed's announcement is any guide, Operation Twist has already made that problem worse. The last thing markets needed right now was a clear signal from the Fed that it's in panic mode, but that's exactly what they've been given.

Moreover, Operation Twist is likely to make life more difficult, or at any rate less profitable, for both banks and insurance companies. A flatter yield curve will meean that banks make less money out of their customary maturity mismatching activity -- basically, converting short-term deposits into longer-term loans. It's hard to see how this will encourage them to lend. Insurers, in turn, will find it harder to maintain competitive annuity rates as long-term bond yields are forced lower. This will either take a toll on insurers' profits or -- more probably -- on the incomes of Amwerica's retirees.

By coincidence, the Fed action comes in the same week that the IMF has released its latest Global Financial Stability Report, a document of wrist-slitting gloom. One of the Fund's key concerns, evidently not shared by Ben Bernanke and co., is that loose monetary policy creates its own unique set of risks. As reported by Reuters, the IMF warns that low rates mean that "investors are struggling to meet their return hurdles. This revives the need for excessive leverage in the quest for yield".

Sound familiar? It should, because this was a big part of how the global economy and financial system got into crisis back in 2007/08. Mispricing of risk as a result of decade-long ease in monetary policy and the infamous "Greenspan put" led directly to large scale, highly leveraged risk taking, focused on the US housing sector.

We all know how that worked out, but it's hard to escape the conclusion that the Fed's latest proposed cure is more of the same. Maybe the appropriate musical reference here isn't Chubby Checker, but the much less renowned Canadian rocker Ian Thomas, whose biggest hit was "You gotta know this isn't working".