If Higher Rates Loom, Will the Fed Twist?

Published: November 15, 2002
COME on, let's twist again, like we did last century.
Alan Greenspan this week brought back memories of ''Operation Twist,'' the last time the Federal Reserve he now leads set out to manipulate long-term interest rates.
Testifying on Capitol Hill, Mr. Greenspan was reminded that the federal funds rate -- the short-term rate the Fed controls -- is down to 1.25 percent. What could the Fed do if it needed to ease monetary policy when rates were already near zero?
It could buy long-term Treasuries, the chairman replied. ''As a consequence, there's virtually no meaningful limit to what we could inject into the system were that necessary.''
Mr. Greenspan gave no hints he was planning to do any such thing. But it is an interesting idea and may come back if the current ''soft spot'' in the economy, as Mr. Greenspan described it, turns out to be quicksand.
The original Operation Twist was conceived in 1961 by the Kennedy administration, which felt a need to lower long-term rates to stimulate business investment, while at the same time raising short-term rates to deal with a current account deficit that was putting pressure on the dollar. Thus the ''twist'' on interest rates.
The twist was not wildly successful, but neither was it a clear disaster. The dollar survived another decade before it had to be devalued as the era of fixed exchange rates ended. And a long period of economic growth began in 1961.
But it is not hard to understand why Mr. Greenspan would be thinking about long-term rates. The current economic recovery, choppy and tentative as it is, is dependent on long-term rates' not rising, and it may even need further declines. Since businesses overinvested in the boom and are still looking for ways to cut costs, the housing market has become the engine of growth. Rising home prices make consumers feel wealthier and willing to spend, and refinancing mortgages gives them the cash to do so.
One key to the strength of the housing market is that buyers and sellers of homes look at prices differently. The seller thinks the home sells for, say, $275,000. The buyer focuses on the monthly payment after the down payment: $1,499 on a 30-year, $250,000 loan at 6 percent. In 1990, with 10 percent mortgage rates, that same monthly payment covered a $160,000 loan. A drop of four percentage points has allowed buyers to get a 56 percent larger loan.
Were mortgage rates to rise now, the economic stimulus from refinancings would vanish. Then people with adjustable rate mortgages would have to pay more. Finally, the higher mortgage costs could make so many buyers unable to pay current prices that those prices would fall. And that wealth effect could cause consumers to cut back on spending far more than they did after their stocks lost value.
The aftermath of the bubble can be seen in the disarray of companies like Lucent and in the determination of nearly all companies to control capital spending. This economy needs consumers to keep spending until those imbalances are worked out, and there is no telling how long that will be.
At the moment, consumers are becoming even more important. The federal government can run deficits as it pleases, but state and local governments are being forced to reduce spending and raise taxes. That will apply an economic drag.
The odds still favor the economy's staying out of recession, and there is no obvious reason to expect higher rates any time soon. But it is understandable why the Fed would be nervous. Higher long-term rates could badly damage this economy. Mr. Greenspan could yet be called upon to do the twist.

NOW THAT'S A TRADE!! Twist and shout!