September 20, 2011

Operation Twist, QE3, and What the Fed Should Do

As the FOMC wraps up on Wednesday, it looks like the Federal Reserve is considering a couple of different options: ‘Operation Twist’ and another round of quantitative easing.

The point of Operation Twist is to help those on fixed incomes and, in turn, stimulate some consumer spending. In the short term, it could help a little by raising interest rates from 0% to 2% and giving people a little more money to spend.

However, it’s not certain people will spend any of the extra money; because right now people are too scared to invest or spend. The data supports this by showing most people are focused on saving and paying down their debt.

The odds are it won’t work over the long term or have any effect for the overall economy because the housing market has shown no reaction to record-low interest rates.

For businesses, how much lower can we push interest rates to get them to invest? If they aren’t excited now, rates can’t get much lower—and we’re becoming more and more like Japan.

Still, chances are the Fed will do something dramatic (such as more quantitative easing), because the European crisis is coming to a head and the EU is our biggest trading partner. The good news is that, as Europe implodes, the U.S. becomes more attractive to investors and rates will be pushed lower. It’s a double-edged sword though: lower rates are good, but the weakening of our biggest trading partner is not.

QE3 will probably not work, because banks are scared, too, and do not want to lend. The problem is like the chicken and the egg—which one should we work on first?

Half of Operation Twist would help: Raising short-term rates to mute inflation will drive prices down and leave people a little better off, but leave the long-term rates alone.

Nothing the Fed does will really help the long term. We don’t have a monetary problem, we have a fiscal problem. We’re in the aftermath of a horrific credit-bubble and it will take years to recover.