Friday, October 28, 2011

A Brief Note on the Limited Power of the Fed

Some people give the Fed too much credit while others give it too much blame.  As an example of the limits of the power of the Fed, consider the aftermath of Operation Twist.  Briefly, Operation Twist is the Fed's latest attempt to try to stimulate economic growth by selling short-term Treasury bills and buying medium-to-long-term Treasury notes and bonds.  By purchasing medium-to-long-term bonds, it hoped to reduce interest rates that would more directly affecting borrowing (consumers and businesses tend to borrow for long periods of time; 5-year auto loans, 30-year mortgages, etc.).  After declining to about 1.7%, the yield (interest rate) on ten-year Treasury bonds rose to 2.4% yesterday, despite the Fed's actions.  Financial markets are much bigger than the Fed and thus many other factors have a larger impact on interest rates.  In this case, reduced fear over the European debt crisis along with perceptions that the US economic growth is slightly stronger than previously expected reduced the attractiveness of US bonds, resulting in a significant increase in market-based interest rates. Though the Fed is powerful, its power is limited.