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We've seen quantitative easing before - and it didn't work Add to ...

Do you remember Operation Twist? Most investors don't, but this nearly forgotten piece of history holds important lessons for anyone trying to forecast what 2011 will hold for the North American economy.

The Kennedy administration launched the operation in February of 1961 (when the Twist was the latest dance sensation) and continued it until 1965. Despite the whimsical name, Operation Twist was a precursor of today's quantitative easing.

Operation Twist involved buying Treasury bonds while simultaneously selling T-bills. By creating demand for long-term bonds while at the same time increasing the supply of T-bills (which mature in less than a year), the Fed hoped to push up Treasury prices while pulling down T-bill prices.

Interest rates move in the opposite direction to bond prices, so in theory all this buying and selling should have reduced longer-term interest rates while boosting short-term interest rates.

The U.S. Federal Reserve hoped that twisting interest rates in this fashion would support the U.S. dollar by attracting capital from abroad with higher short-term interest rates. It also expected the operation would stimulate investments and the economy through lower long-term interest rates. Since mortgages are tied to long-term interest rates, the Fed hoped that Operation Twist would help lower consumer interest rates and increase demand for mortgages and housing.

But Operation Twist failed, according to economists Franco Modigliani and Richard Sutch. Long-term yields rose instead of falling - perhaps because the entire operation was relatively small. In all, the Fed bought $9-billion (U.S.) in Treasury bonds, amounting to just 1.64 per cent of GDP at the time.

Flash forward to 2010, when the Fed is once again attempting to affect interest rates through quantitative easing, a process of buying longer-term Treasuries with the goal of lowering long-term yields to stimulate investments and growth.

QE, along with an increase in the money supply, is supposed to tilt interest rates to a lower level. Rather than twisting the yield curve (the differential between long- and short-term interest rates), the recent developments should shift both long- and short-term interest rates to a lower level.

The hope is that this will result in a lower value for the U.S. dollar, encourage domestic investments, lower mortgage rates to support housing and make U.S. goods more competitive worldwide.

But two questions emerge. First, since a variation on QE didn't work before, does it have any hope now? Second, will it trigger a bout of inflation?

In terms of size, the commitment to QE is larger than it was to Operation Twist, with $600-billion allocated to the latest round, or about 4 per cent of U.S. GDP. But overall, that's still a small amount relative to the size of the economy.

QE is a gamble for other reasons. According to one theory of what affects the shape of the yield curve, long-term interest rates are the average of the market's expectations for short-term interest rates at various points in the future. If this is the case, the Fed must change expectations if it wants to lower long-term rates. And it's by no means clear that a short-term QE program can affect expectations if it's seen as just a temporary disruption.

The Fed actions may actually increase long-term interest rates if markets expect the added liquidity to help the economy. But this could have benefits: Even though the Fed may fail in lowering interest rates, it may succeed in creating an expectation of a better economy.

And what about inflation? Many people worry - with good reason - that the amount of money being pumped into the economy through QE will raise prices.

You can measure the likelihood of inflation by comparing nominal bond yields (which include the impact of inflation) with real bond yields (which strip out the effect of inflation). Real bond yields are a good guide to how quickly the market expects the economy to grow in real, inflation-adjusted terms, while nominal bond yields indicate expectations for both real growth and inflation.

A look at these two yields since Nov. 3, the day the Fed announced the latest round of QE, shows that real long-term rates have remained mostly flat in Canada and risen in the United States. Meanwhile, nominal long-term rates have increased sharply in both countries.

This is not a happy outcome. Investors appear to be expecting higher inflation and are demanding higher nominal yields to compensate.

While the behaviour of real interest rates suggests that the economic outlook may look better in the U.S. than in Canada, my view is that it will not be characterized by vigour in either country and much of the growth will be inflationary. Operation Twist disappointed; QE is not likely to do much better.



George Athanassakos, gathanassakos@ivey.uwo.ca, is a Professor of Finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, The University of Western Ontario.



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