Why did the Fed 'twist' back in 1961?
- 22 September 2011
- From the section Business
February 1961. In the US, John F Kennedy had just been elected president on a message of hope amid a recession.
Lawrence Welk's Calcutta was the number one song, Walt Disney's One Hundred and One Dalmatians had just been released and Chevys lost their tailfins.
It was also the month that the US central bank, the Federal Reserve, decided to embark on what became known as Operation Twist to stimulate the moribund economy.
The nickname comes from both the twisting involved with the yield curve of US debt and the twist dance craze, from the classic Chubby Checker song of the time.
Much has changed since then, but 50 years later, a very different group of central bankers at the Fed this week decided the time had come to revive the policy.
Operation Twist Redux, announced on Wednesday, is designed to lower the long-term cost of borrowing by selling short-term debt and buying longer-dated bonds.
But why did the Fed embark on this road in the first place back in 1961?
At the time, the US was running a deficit in its balance of payments. This means that more money was leaving the country than entering - because of the US paying out more for its imports than it was receiving in payments for its exports.
Adam Zaretsky, an economist at the Federal Reserve Bank of St Louis, explains this by referencing the currency situation of the time.
The currencies of the world were pegged to the US dollar under a post-war agreement, and the dollar was fixed to gold. So to pay off its creditors, the US had to sell gold.
"As a result, gold was leaving the United States at what was considered an alarming rate, with even greater losses foreseen," Mr Zaretsky wrote in his 1993 paper, To Boldly Go Where We Have Gone Before.
Coupled with the slowing economy, the Fed decided to take action in February 1961 to "flatten the yield curve" - banker-speak for lowering the yields on longer-bonds.
So they would sell short-term bills and buy longer-term bonds.
This was an unprecedented idea. In discussing the policy at the February 1961 meeting, the central bankers referred to the policy as an "experiment".
The Fed justified the action by saying that by buying and selling, the central bank was not adding more money into the economy or affecting short-term borrowing.
That month, central bankers authorised its New York arm to buy a maximum of $500m of US debt, maturing in up to 10 years.
In its annual report in 1961, the Fed said the goal of the policy was: "To encourage bank credit and monetary expansion while avoiding direct downward pressure on short-term interest rates, thereby moderating pressures on the US balance of payments."
The discussion of the "experiment" did not proceed totally smoothly.
While the vast majority voted for Operation Twist, one governor, J L Robertson, voted against the idea.
He argued that the decision was being taken using the "simplest theories of determination of market interest rates and making allegations on postulates having little if any basis in empirical fact".
The minutes of the meeting show that Mr Robertson also said, if the Fed must do this, they should explain their actions to the market.
The rest of the committee quickly vetoed this suggestion.
It was "brought out and strongly emphasised that there was a real risk that this test might be frustrated if word got around the market that system purchases of longer terms were just an experiment".
This is not surprising. The Fed was so secretive that it didn't even announce its interest rate decisions until 1994.
The decision dramatically restructured the Fed's holdings - the central bank's holdings of bonds shot up 51% from 1960 to 1961.
Operation Twist lasted from 1961 to 1965, when it was officially ended. But did it work?
The yield curve did flatten in that time, meaning that longer-term interest rates fell.
But Mr Zaretsky argued that some economists argue this was more due to the recovering economy.
He quotes economist Benjamin Haggott Beckhart, who studied the Fed and said: "Long-term interest rates cannot be substantially reduced by money market gimmicks."
Now the Fed is about to have another go at the policy.
Many economists are sceptical as to whether it will have a bigger impact on the economy now than it did in the Sixties, but with interest rates near zero, there are few options left to the US central bank.
If this Operation Twist doesn't succeed in stimulating the economy, investors may be asking the Fed governors the same question Elvis Presley posed in his massive hit of 1961: "Are You Lonesome Tonight?"