The Fed Keeps Twisting in Its Quest for Lower Rates

(Updates with economic projections and comments from Ben Bernanke’s press conference.)

The Federal Reserve will keep spiking the punch bowl at the economic dance party through the end of the year. The Fed said Wednesday it will continue what economists like to call Operation Twist, an attempt to bring down long-term interest rates to stimulate economic growth. The operation “should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative,” the Federal Open Market Committee said in a written statement.

William McChesney Martin, who chaired the Fed in the 1950s and 1960s, once said that the central bank’s job was to “take away the punch bowl just as the party gets going.” But under Chairman Ben Bernanke, the Fed is more worried about the ho-hum party grinding to a complete halt. Rate-setters are trying to push mortgage rates to historic lows to revive the housing market, which is a key to overall growth.

The concept of Operation Twist is to sell some of the Fed’s short-term Treasury securities and use the money to buy long-term ones—to “twist” the maturity of the portfolio. Short-term rates are already super-low; the objective is to bring longer-term rates down as well by shifting demand. The original program, announced last September, was set to expire at the end of this month with $400 billion shifted. Now the Fed will reallocate a further $267 billion toward long-term securities through the end of 2012, leaving it with precisely zero in short-term Treasuries.

While the Fed is twisting, it isn’t quite shouting. Shouting would be taking the more extreme measure of adding to the size of its bond portfolio, which already stands at about $2.7 trillion. The current program shifts the maturity of the portfolio without making it bigger.

Will this help? Probably some, but not a lot. Low mortgage rates—the 30-year fixed rate average is currently 3.71 percent— have already made houses the most affordable they’ve been in decades. The problem for many potential buyers is not the cost, but their inability to get a loan because of damaged credit. The Fed’s initiative won’t do anything about that.

The rest of the Fed’s statement was as expected: It darkened its portrayal of the economy’s health and repeated its prediction that weak economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.” Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, dissented from the open market committee’s decision, opposing the continuation of Operation Twist.

The Fed is now looking for 2012 economic growth of just 1.9 percent to 2.4 percent [PDF], down sharply from the range of 2.4 percent to 2.9 percent in April. That’s the range excluding the three highest and three lowest forecasts. It includes predictions from all of the Federal Reserve governors and bank presidents, not just the ones currently voting on the Federal Open Market Committee. The new unemployment prediction is for a fourth quarter 2012 average of 8 percent to 8.2 percent, up from 7.8 percent to 8 percent.

At a press conference, Bernanke fended off questions about whether the Fed wasn’t doing enough, or was doing too much. His most intriguing answer was in response to a question about a new initiative of the Bank of England–the Fed’s counterpart in Britain–to require that banks lend more to consumers and businesses as a condition for receiving new, long-term loans from the central bank. It’s called the “Funding for Lending” program, and details remain vague.

“We’re very interested in it and we’re certainly going to follow it,” Bernanke said. American banks have been criticized in some circles for taking funds from the Fed and not boosting lending. They say the problem is a lack of demand for loans, not an unwillingness to lend. Bernanke said the Bank of England’s plan may involve a subsidy from the British Treasury. A subsidy would presumably become necessary to compensate the Bank of England if banks defaulted on their loans. BBC Economics Editor James Peston says that, based on what he has been told, “the issue of whether taxpayers will guarantee the scheme is not definitively settled.”

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Why Lower Natural Gas Prices Help the U.S. Only a Little

There’s a rule of thumb that says a $10 rise in the price of a barrel of oil reduces gross domestic product growth by anywhere from 0.2 to 0.5 percentage points. Applied over the past six months, when crude prices rose by about $30 from early October to the end of March, that means dearer oil might’ve chewed as much as 1.5 percent out of GDP growth during the last two quarters. Not a trivial amount considering GDP increased 3 percent in the fourth quarter of 2011. Economists surveyed by Bloomberg tend to think the economy grew just 2.2 percent in the first three months of 2012, when the price of gas really took off.

Oil is our economy’s most important raw material. The price of it (and therefore, gasoline) impacts the price of just about everything we buy, from groceries to clothes to appliances. The more expensive oil is, the more expensive a whole lot of other stuff becomes. But what about that other gas, the kind that we’re practically swimming in these days? Natural gas is now 80 percent cheaper than it was four years ago. How much has that price decline counteracted our recent pain at the pump?

Unfortunately, not much. On the consumer side, at best you’ve seen a small reduction in your electricity bill. Natural gas has certainly played a part in slowing the pace of rising residential electricity prices, from an average annual increase of 5 percent between 2003 and 2008, to 0.8 percent from 2009 through 2013. Rates are actually forecast to fall 1.4 percent next year. According to the consumer price index, the cost of utility gas service for heating declined 9.1 percent over the past year. But that’s a relatively tiny portion of what we spend our money on—less than 1 percent. Motor fuels, on the other hand, carry a relative importance of 5.8 percent and have increased 9 percent in price over the past 12 months. So whatever you might’ve saved on your electric or home heating bill, you probably plowed right back into your gas tank.

Cities with public buses that run on compressed or liquefied natural gas have benefited from lower fuel costs. And if you happen to be one of the handful of people in the U.S. who drive a natural gas car, you’re probably coming out ahead on your fuel bill every month—especially in California, which has the bulk of the country’s 400 public natural gas fueling stations, and where regular gasoline prices are among the highest.

Manufacturers have certainly benefited from lower natural gas prices. The fuel is a particularly critical input for the petrochemical and refining industry, giving U.S. firms a big cost advantage over international competitors—as much as 70 percent over manufacturers in South Korea and Europe. Whether cheap natural gas is propelling any of the strong job growth in the manufacturing sector over the past couple years is debatable. It’s certainly making a lot of manufacturers more profitable. On the flip side, it’s been bad for producers. As prices have plummeted it’s become uneconomical to keep drilling for gas. There’s a good chance that if you were working on a natural gas drill rig a year ago, you’re not anymore.

Big picture as of today, cheap natural gas hasn’t done much to counteract the run-up in oil prices. “So far it’s been a pretty small positive,” says Mark Zandi, chief economist at Moody’s. That doesn’t mean that in the future it won’t pay big dividends for the U.S.—particularly, as Zandi points out, if we’re able to get more natural gas into our transportation network. T. Boone Pickens wants to retrofit our long-haul trucking fleet to run off natural gas. There’s evidence that’s starting to happen. If done on a large enough scale, that could take a big bite out of the impact high oil prices play in driving up the costs of goods.

We’re also severely limited in our capacity to export natural gas right now. The U.S. has just one export facility, in Alaska. A recently approved LNG export terminal in Louisiana will bring that to a grand total of two once completed in 2015. Regulators aren’t likely to approve any more LNG export projects in the coming year, though they probably will in the future. Depending on domestic demand, abundant natural gas could significantly reduce the U.S. trade deficit and perhaps turn us into a net exporter.

Although we have massive amounts of natural gas—an estimated 2,214 trillion cubic feet, enough to last 100 years by some measures—we still don’t use that much of it. Case in point: We’re drilling so much and using so little, it’s conceivable that we’ll max out our 4.3 trillion cubic feet of storage capacity at some point this year. Americans burn about 22 trillion cubic feet of natural gas every year, enough to fill up about 595,000 Empire State Buildings. But we could use a whole lot more, and certainly will soon. Until we do, the U.S. economy won’t see that big of an upside from cheap prices.

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