Should the Fed Go Long?

I missed this bit from Bernanke in my earlier post:

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

The buying of longer-term Treasuries is not a tool that the Fed has pulled out very often. The most famous example happened at the start of an administration led by a young, handsome, and charismatic Democrat. This from Floyd Norris in 2002:

The original Operation Twist was conceived in 1961 by the Kennedy administration, which felt a need to lower long-term rates to stimulate business investment, while at the same time raising short-term rates to deal with a current account deficit that was putting pressure on the dollar. Thus the ''twist'' on interest rates.

The twist was not wildly successful, but neither was it a clear disaster. The dollar survived another decade before it had to be devalued as the era of fixed exchange rates ended. And a long period of economic growth began in 1961.

Also in 2002, Bernanke said in a speech that comparisons to the Kennedy plan should be made with care:

Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were not close to zero.

Economists at Wrightson-ICAP also point out that Operation Twist was a joint effort by the Treasury and the Fed (Good thing Geithner is heading to Treasury then). Further, the Treasury could save the Fed from having to expand its balance sheet -- and potentially adding to inflationary pressures -- by changing the mix of debt that it offers.

Our own guess, Bernanke's comments notwithstanding, is that the Fed ultimately will decide that it faces enough demands on its balance sheet without loading up on Treasury bonds as well. However, the same result might be achieved through adjustments in the mix of new issuance by the Treasury. If policy-makers have actually been contemplating the possibility of operations farther out the Treasury yield curve, it is possible that implementation will be left to Tim Geithner at Treasury rather than Ben Bernanke at the Fed.