Federal Reserve Purchases Of Treasuries, The Yield Curve, And Operation Twist

We get evidence frequently these days of the relative youth of those on financial television, both interviewers and interviewees. Their historical frame of reference doesn’t go back very far; so they miss obvious historical precedent for contemporary issues. In my June 10 post, I discussed the Fed’s ill-fated attempt to remove excess reserves from the banking system in the 1930s. In this one I feature the Fed’s announcement, and the reaction to it, that the Fed would purchase longer term treasuries in an effort to depress longer-term interest rates, including mortgage rates.

Since short-term rates under the Fed’s influence are near zero, a policy of targeting longer-term interest rates represents an effort to change the term structure of interest rates or the slope of the yield curve as it is usually put today. This policy is usually treated as unprecedented. Not so. A similar policy, but for different reasons, was undertaken in the 1960s and was called “Operation Twist.”

In the early 1960s, especially around 1963, the Fed purchased longer-term U.S. securities to put downward pressure on longer term interest rates considered important for domestic growth while trying to keep short term rates high enough to prevent a capital outflow. The balance of payments constraint imposed by fixed exchange rates precluded an across-the-board reduction in interest rates.

Sometimes the Fed would purchase longer term Treasury securities while selling shorter maturities at about the same time. The Fed had two interest rates policies at the same time: short rates targeted the balance of payments while long rates targeted domestic demand and growth. As indicated above, this policy of pushing down long rates while supporting short rates came to be known as “operation twist.”

Operation twist was deemed necessary because fixed exchange rates imposed a discipline on policy that the Fed doesn’t have today with flexible exchange rates, although many pundits wish that constraint were still there.

If operation twist was successful in achieving its objectives, it was only mildly so. The historical verdict was that it made little difference.

A companion program to sustain our balance of payments without adopting policies that would hurt the domestic economy came along later in the 1960s. Called the “Voluntary Foreign Credit Restraint” program, or VFCR, its objective was to jaw bone banks into “voluntarily” limiting capital outflows. I was assigned to that program briefly, and it was the only assignment in my long tenure at the Fed that I found distasteful. Fortunately, it went away before it did much damage.

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