Operation Twist: A Dustoff for the Economy

Over the last few weeks, Google has seen an outpouring of searches on "Operation Twist" and Chubby Checker! The link between the two is the fact that it was Checker's song "The Twist" that inspired the coining of this monetary policy.

Let us now look at what exactly Operation Twist is and how does it affect us?

Operation Twist has been conducted by the US Federal Reserve two times over the course of History: once in 1961 and then again, 50 years later, in 2011. 1961 was just after the Korean War, when the US was reeling with recession and Operation Twist enabled the strengthening of the dollar and stimulating the inflows of cash into the economy.

The Yield Curve was flattened and had its ends twisted (hence the name!), due to the selling of short-term bonds and the consequent buying of long-term ones using the proceeds of those sales.

When the Feds purchased the long-term bonds, the prices went up but the yield had an opposite effect (as there is an inverse relationship between yield and bond price). This operation, however, involves keeping the short term (2-3 years) rates unaltered resulting in the yield being constant, even though the short term bond prices would definitely have reduced, owing to the short term bonds being sold by the Fed. This is primarily because the short term yield generally depends on the expectations of the Federal policy. Hence, the long-term yield is the one that is mainly affected because of this operation.

2011 presented a different problem, whose solution was basically the same. Short term interest rate, during this time, had reduced to zero. To counteract this, the Fed had to reduce the long-term yield, by purchasing long-term treasury notes and bonds, and selling off short-term treasury bills and notes. The 10 year interest rate fell to as low as 1.95% with the two year interest rate being ~0, thereby greatly reducing the spread (between the long term and short term rates).

The RBI, in an effort to improve the economic conditions back home, has taken a leaf from the booklet of the US Federal Reserve.

To understand how it affects us, we need to dig a little deeper into the current economic scenario, back home.

In the last one year, RBI has cut the repo rate, the rate at which RBI lends money to the banks, by a cumulative 135 basis points. It was thought that this would lead to banks, in turn, reducing the rates at which they lend, which, may have gone a long way in improving the otherwise gloomy economic scenario prevailing in the country at the moment. The banks, however, did reduce the rates, but not in keeping with the reduction of repo rate. The reduction in the average weighted lending rate was a relatively meagre 40-47 basis points. The banks, could also not be blamed as they needed to take necessary steps to prevent the occurrence of NPAs, which have lately been inflicting a lot of damage on the financial structure. When the loan period was short, the banks were ready to lend at a lower rate, but as the period increased, the lending rate became pretty steep. This was in tandem with the high deposit rates for long term deposits, such as, FDs: to attract such deposits, the banks were forced to increase the interest rates on those deposits.

The fears of an impending stagflation were further highlighted by the fact that even after the last MPC, when the RBI decided not to cut the repo rate further, the yield of the 10 year Government Securities increased by 33 basis points to 6.8%.

Thus, on December 19th, RBI decided to undertake the desi version of Operation Twist, by purchasing INR 10,000 Cr worth of government securities, and selling four government bonds worth the same amount, thereby reducing and controlling the long term interest rate (and resulting yield) and reducing the spread between the long term yield and the short term yield.

Since then, there has been a reduction of about 17 basis points in the benchmark yield. This decrease in yield would propel more investors to look for alternative areas of investment, with FDs being a prime target. And with the increase in retail investors investing in FDs, the banks would not really have to keep their deposit rates so high, which, as a result, might lead to them reducing the interest rates of long term loans.

The consumers and businesses, in turn, would be able to avail cheaper loans, and use them to invest, expand and spend, thereby perpetuating a healthy monetary transmission.

Reduction in long term yield after Operation Twist

By selling government bonds, RBI also ensured that the money supply was kept in check, thereby controlling inflation. Buying the government securities would definitely have led to an increase in money supply and resulting inflation, which was effectively countered by the selling operation.

This is the whole idea behind Operation Twist and it is expected to boost the economy, which has been going through a bit of a downturn.