Does the Central Bank Control Long-Term Interest Rates?: A Glance at Operation Twist

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Although less prevalently talked about today many economists assume that while the central bank has control over the short-term rate of interest, the long-term rate of interest is set by the market. When Post-Keynesians make the case that when a country issues its own sovereign currency the rate of interest is controlled by the central bank and that the government never faces a financing constraint some economists deny this and point to the long-term rate of interest which they claim is under the control of the market. They say that if market participants decide to put the squeeze on the government they can raise the long-term rate of interest.

Keynes himself was wholly convinced that the central bank had full control over the long-term rate of interest. In a 1933 open letter to US President Franklin Roosevelt Keynes wrote:

The turn of the tide in great Britain is largely attributable to the reduction in the long-term rate of interest which ensued on the success of the conversion of the War Loan. This was deliberately engineered by means of the open-market policy of the Bank of England. I see no reason why you should not reduce the rate of interest on your long-term Government Bonds to 2½ per cent or less with favourable repercussions on the whole bond market, if only the Federal Reserve System would replace its present holdings of short-dated Treasury issues by purchasing long-dated issues in exchange. Such a policy might become effective in the course of a few months, and I attach great importance to it.

What Keynes was advocating was what has since been referred to as Operation Twist. This was a policy that was first initiated in the US during the Keynesian heyday under President John F. Kennedy. The Wikipedia page provides a nice overview of how it worked — note how it is identical to Keynes’ suggestion in his 1933 letter:

The Fed utilized open market operations to shorten the maturity of public debt in the open market. It performs the ‘twist’ by selling some of the short term debt (with three years or less to maturity) it purchased as part of the quantitative easing policy back into the market and using the money received from this to buy longer term government debt.

The policy basically did nothing. Below are the interest rates of the era.

10year1960sAs we can see the long-term treasury yield responded to the lowering of the Fed funds rate in 1960 but we can detect no change between the spread of the short-term and the long-term yield in 1961. The spread begins to close in 1962 but this is as a result of the increases in the Fed funds rate.

Recently the Federal Reserve Bank of San Francisco released a study claiming that the program had actually worked. I won’t get into the methodology of the study but I think its basically rubbish. The fact is that the stated aim of the program did not come to pass in any meaningful way. But the reason that the Fed probably commissioned the study was because they tried Operation Twist again once more in 2011. The Fed described the program thus after it had been completed:

Under the maturity extension program, the Federal Reserve sold or redeemed a total of $667 billion of shorter-term Treasury securities and used the proceeds to buy longer-term Treasury securities, thereby extending the average maturity of the securities in the Federal Reserve’s portfolio. By putting downward pressure on longer-term interest rates, the maturity extension program was intended to contribute to a broad easing in financial market conditions and provide support for the economic recovery.

So, did it work? Not unless the Fed were lying about when they started the program. The press release at the time dates the program to September 21st 2011. Keeping that in mind let’s look at the long-term interest rates in that period. (We do not bother showing the short-term interest rates here because, as everyone knows, they are basically zero throughout the period).

10year2011-2012Do you see that significant drop in long-term interest rates of about 1%? Well, that occurs in July 2011 and reaches its bottom in September 2011. This opens the possibility that the Fed actually undertook the program two months before they announced it. Unfortunately, there is no hard evidence of this and unless such evidence emerges we must assume that the second attempt at Operation Twist was indeed a failure.

Does this mean that Keynes was wrong and that the central bank does not control the long-term rate of interest? No. Keynes was actually confusing two distinct things in his letter to Roosevelt; namely, whether the central bank controlled the long-term rate of interest and whether it controlled the spread between the short-term and the long-term rate of interest. There is no evidence that the central bank has any meaningful control over the latter — although I am open to being proved wrong on this front should it ever turn out that Operation Twist II was actually initiated in the summer of 2011. But if we zoom out it is quite clear that the central bank has full control over the long-term rate of interest. (Click for a larger picture)

interest ratessss

On the left I have graphed all the interest rates together. The pattern should be clear to the reader. But in order to be concrete I have also included a regression of the the Fed funds rate on the ten-year bond yield. As we see the relationship is positive and quite statistically significant. It is quite clear that the central bank controls the long-term rate of interest through its short-term interest rate policy. Indeed, the fact that the regression does not produce a perfect fit is mainly due to the fact that the spread between the long-term rate and the short-term rate widens whenever the Fed drops the short-term rate significantly — this can be seen quite clearly in the graph on the left.

Some will claim that the long-term interest rate is actually tracking inflation. That is, when inflation rises the long-term interest rate would rise. Then the central bank merely reacts to this inflation by raising the short-term rate thus giving the statistical illusion of control. But this is not the case. If you look at the data carefully it is clear that it is the short-term rate driving the long-term rate and not inflation. There are many ways to illustrate this but perhaps the easiest is to run a regression of the long-term interest rate against the CPI which I have done below.

10 year and inflationAs we can see the fit is far less statistically significant than when we ran the regression of the short-term interest rate against the long-term interest rate. This shows quite clearly that, although the short-term rate may be raised by the central bank in response to inflation, it is clearly the short-term rate that is driving the long-term rate and not the rate of inflation.

So, does the central bank control the long-term interest rate? Yes. Does it control the spread between the long-term rate and the short-term rate? There is no evidence to confirm this and the evidence that we do have — taking the Fed at its word — suggests that they do not. But regardless, next time some economists tells you that the markets control the long-term rate of interest you can safely tell them that they have absolutely no idea what they are talking about.

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About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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14 Responses to Does the Central Bank Control Long-Term Interest Rates?: A Glance at Operation Twist

  1. NeilW says:

    “There is no evidence to confirm this ”

    If a central bank stands ready to purchase any ten year bond at the price that is equivalent to a yield of 0.5%, then the ten year bond will yield 0.5%.

    A central bank can set the minimum price of anything listed in its own currency by means of its ability to issue infinite amounts of 0% permanent bearer bonds on which the price is based.

    Swapping maturities around on the bonds themselves within the existing liquidity pool I’m not sure will do much to change the time premiums. In that case the central bank is just another market participant.

    If the central bank wants to control anything it has to use the power only it has.

    • I think they could too. But we have no actual evidence.

      • NeilW says:

        Probably because nobody has ever done it. It’s always a limited intervention that will therefore be scuppered by expectations.

        As usual in economics you just can’t conduct the necessary experiments to prove things.

      • – The Fed did “peg” long-term interest rates for a decade, until the Fed-Treasury Accord of 1951. They did move around, but they remainded below an upper limit of 2.5%. Other countries followed similar policies.
        – Pegging bond yields implies a need for extensive regulation of credit creation. Otherwise, the central bank just buys up the stock of government bonds, and private sector yields decouple from the now non-existent govvie yield curve. This removes the ability of monetary policy to influence the economy.
        – A lot of analysis of Operation Twist in the 1960s argued that it failed because the Treasury lengthened the duration of issuance, cancelling out increasing Fed purchases. The Treasury has done exactly the same thing during QE. Most studies of QE ignore the duration change issue, as that would require a lot of programming that cannot be done in the statistical packages economists are used to.
        – Most modern macroeconomic models (e.g. DSGE) assume that bond yields are determined entirely by short rate expectations, that is, the term premium (or as Keynes described it, the liquidity premium) is zero. (Finance models have a term premium.) Therefore, bond yields are allegedly entirely determined by the central bank reaction function, and the “parameters” of the economy. I would not view that as “market determined”, but that turns into a debate over the definition of “market determined”.
        – With regards to “bond vigilantes”, the main question is whether independent central banks can hold the Treasury hostage? Even though a central bank could ensure financing of government debt, will it? (For example, look at ECB behaviour a few years ago.)
        – I would argue a more important question is: why does a government that controls its currency care whether its bond yields are “too high”? As long as the central bank cooperates, it cannot default. Interest payments are made to determine a yield curve to regulate economic activity (which is a consensus view, even amongst many branches of Post-Keynesianism). If the interest rates are “too high”, it will show up in the data, and the condition would be corrected at some point. The same holds for “too low” yields.

      • philippe101 says:

        Brian,

        “Pegging bond yields implies a need for extensive regulation of credit creation. Otherwise, the central bank just buys up the stock of government bonds, and private sector yields decouple from the now non-existent govvie yield curve. This removes the ability of monetary policy to influence the economy.”

        So, the MMT proposal to keep the overnight rate at or near zero would imply a need for extensive regulation of credit creation, right?

      • In response to Philip’s questions about zero rates in MMT, yes the implication is that the regulatory framework would have to adjust. The MMT proposal for zero rates is easier than pegging bond yields at non-zero levels, as the idea is that there are no more bonds.

        The central bank would have no influence over interest rates in the private sector, as the risk free rate cannot be changed. Thus, there would be no way to slow down excessive credit creation other than by fiscal policy. The main MMT authors are skeptical about the ability of interest rates to control the economy; I am undecided about that issue (although I think the sensitivity of the economy to interest rates is lower than the consensus believes). But the MMT view is that even if there is some loss of control, fiscal policy and regulation can make up for it.

        I think the 0% rate proposal has other problems. One of which is that government bonds stabilise private sector potfolios and provide liquidity. If they are not held, it is harder to avoid a downward spiral in a credit crisis, as all private sector securities become suspect.

      • Scott Fullwiler says:

        Note that the MMT proposal for zero short-term rate is coupled with strong regulation of credit creation based on Minskyan principles. It does not necessarily stand alone from those. And it doesn’t mean the CB shouldn’t work on affecting other rates that pvt borrowers face via adjusting capital requirements, etc.

        Indeed, an appropriate MMT-based regulatory system to accompany zero short rates would have been strongly discouraging the vast majority of mortgage activity during the 2000s and thus raising rates on those products, if not forbidding them outright.

      • Scott Fullwiler says:

        Also, the MMT proposal is to have the Tsy issue nothing longer than 3 month (though there are some exceptions), so much of this “who sets the yield curve” debate is not relevant to the MMT proposals. In that case, it would largely be the swap markets setting the base for pvt longer-term rates based on expected short term rates (zero for MMT) plus term and default risk premia.

  2. LK says:

    Regarding the 1960s Operation Twist, Bill Mitchell has a post about that here:
    http://bilbo.economicoutlook.net/blog/?p=8986

    • Yes, he seems to assume that it worked. But the data shows otherwise.

      • LK says:

        Well, it’s a bit unclear what the aims were.

        Bill Mitchell says the point of Operation Twist was to raise yields on short term treasuries (to attract financial flows *into* the US by higher yields), and at the same time to keep yields on long term treasuries stable (but apparently not reduce them).

        Operation Twist lasted from 1961 to 1965. I’m looking at your graph above. It seems like it worked to me (although perhaps you are saying above that the closing in the spread from 1962 was only the result of increases in the Fed funds rate, not the Operation Twist?).

        Have a look at Mitchell’s video at the end of the post.

      • Yes. I think that they narrowed the spread by just hiking the short-term interest rate. There is nothing remarkable about this. It has been done many time before without an Operation Twist. See:

        http://bit.ly/1rcYT0b

  3. Detroit Dan says:

    My interpretation is that inflation fundamentally drives interest rates. You can look into the matter at a finer level of detail, as Phil has done here, but that obscures the fundamental relationship.

    For example, globalization has placed severe downward pressure on wages and this, in turn, has led to continuing disinflation over the past 30+ years. There is a great deal of debate over what the central banks will do and when, but over time they always adjust rates according to the direction of inflation.

    Once you reach the zero bound for short term rates, then the relationship between between short term and long term rates loses its value. So, for example, I have invested in long term government bonds because I see low inflation continuing. (This will of course act to keep short term rates low, but the more fundamental causes are globalization and the resulting downward pressure on wages.)

  4. Olivier says:

    Comparing dated, interest-bearing notes with undated notes does not give you interest rates. You’d need to use spot and forward conversion rates of undated notes into money (Gold) to find out what the actual interest rate is. To figure out 10 or 30 yr interest rates, you would need 10 or 30 yr forward conversion rates of notes into money. I don’t think too many people are stupid enough to sign a 10 or 30 year forward contract tying them to redeem some insolvent ‘central’ bank’s notes. Consequently, one can assert that those banks cannot sell long-dated notes- they are indeed ‘buying’ them all themselves.
    ‘Central’ (Whatever that means) banks don’t control anything beside the lock on the front door, and only until the bankruns take off in earnest.

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