The Federal Reserve, and Operation Twist’s Dubious Past- & it’s Link To Gold

Posted: September 27, 2011 in Gold News, U.S. Economy
Tags: , , ,

Brian Domitrovic- Forbes

Last week, the Federal Reserve announced that it was going to pull off a weird maneuver. It would “twist” interest rates. Through buying and selling different kinds of bonds on the open market, the Fed would try to lower long-term rates and raise short-term ones.

From the depositor’s perspective, the twist hits a false note. When you buy a 5-year CD, you expect a nice premium on a 90-day one. Here the Fed is nailing real savers by encouraging short-term speculation in lieu of long-term reward.

So what’s up? As all the news stories mentioned last week, in the twist the Fed is reprising its own policy from fifty years ago. In 1961, the Fed did the same thing.

Back then, the reason the Fed twisted was two-fold. First, it thought that loose money on the long end would stimulate the economy. There had been a recession in 1960, the fourth in eleven years. The Fed figured that serious borrowers – the ones who borrow long for substantive things like houses and factory expansion – would get going with activity if prime rates were brought down to around 1%.

The second reason was the kicker. The Fed knew that the markets would interpret the loose money as an inflation signal and in turn plow money into gold. The problem was that the U.S. currency at that point was officially collateralized in gold. Foreign monetary authorities could buy gold on demand from the U.S. at $35 per ounce. If the gold price went above that in the private markets, there would be a beautiful arbitrage opportunity.

The increase in short-term rates was meant to ward off such “speculation” in gold. Since gold by definition does not pay interest, stateside bank accounts would remain competitive against the prospect of gold’s capital appreciation.

None of this worked. Foreigners kept buying gold in the face of the rock-bottom long rates, and the U.S. hoard was pressured. Finally the Fed tightened long and a couple of tax cuts came. Money flowed into currency and the real economy on both counts. Everybody forgot about gold for a while as the economy boomed.

You’ve got to wonder why today, the Fed would repeat a move notable for its ineffectiveness. A good guess is that the Fed has been getting sick of watching gold shoot the moon. One way to interpret the price of gold is to see it as the world’s popular vote on the legitimacy of Fed policy. The higher the price, the worse the grade.

So by bucking up short-term rates, the Fed can tease out money that might be heading gold’s way on account of the rock-bottom long rates and all the quantitative easings. Sure enough, on Friday, gold had its biggest one-day drop.

The problem with all this is that it’s just a game. So people are in short-term accounts as opposed to gold. The inflationary expectations are still there. The refusal to invest long is still there. The capital strike represented by $1800 gold is still there, even if gold is in the $1600s.

With fiscal policy from the Obama administration a bevy of tax increases, regulations, and federal appropriations coming down the pike, it should come as no surprise that the Fed feels the need to regress. What else is it to do if the economy sees in fiscal policy the promise of a dead hand?

The historical precedent is clear. The Fed first tried Operation Twist in the context of serial recessions, as a maneuver to prevent further embarrassment on the gold front. Those recessions finally were slipped, and magnificently, at the hands of not the twist, but a policy reversal, a policy innovation, into higher rates in the context of business tax cuts and reductions in every marginal rate in the income tax. The only way the Fed can regain credibility today is if the fiscal sector commits to getting out of the way of an economy aching to boom.

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