1. Let’s Twist Again: A High-Frequency Event-Study Analysis of Operation Twist and Its Implications for QE2 Stanford Macro Seminar April 4, 2011 Eric T. Swanson Federal Reserve Bank of San Francisco The views expressed in this presentation are the author’s and do not necessarily reflect the views of the manage- ment of the Federal Reserve Bank of San Francisco or any other individuals within the Federal Reserve System.

2. Background January 1961: JFK just inaugurated Recession (want to lower interest rates) But European interest rates higher than in U.S., large gold outflows under Bretton Woods system Solution: Lower long-term interest rates but keep short-term rates unchanged Fed would sell short-term Treasury bills and buy longer- term notes and bonds Treasury would issue more short-term bills and fewer long- term notes and bonds.

3. Three Myths Operation Twist and QE2 are conceptually different Operation Twist was small Operation Twist had essentially no effect

4. Operation Twist vs. QE2 Operation Twist QE2 Large gold outflows prevent Fed from lowering funds rate Zero lower bound prevents Fed from lowering funds rate Buy long-term Treasury securities Sell/issue short-term Treasury bills Issue bank reserves (short-term Fed liabilities)

5. Operation Twist Was Big

6. Three Myths Operation Twist and QE2 are conceptually different Operation Twist was small Operation Twist had essentially no effect

7. Operation Twist: Conventional Wisdom Low-frequency (quarterly) time series analysis Modigliani and Sutch (1966,1967) Some inherent problems: Unobserved variables (expectations of future monetary policy, inflation) Large standard errors Endogeneity

8. Event Study Approach Re-examine Operation Twist using modern event study Advantages of event study approach: Other factors affecting macroeconomic outlook held constant Standard errors are smaller Avoids endogeneity problems No evidence of over- or under-response in Treasury market: Jones, Lumsdaine, Lamont (1998 JFE) Fleming and Remolona (1999 JoF) Advantages of Operation Twist period: No financial crisis Foreign official purchases were tiny

9. Event Study: Markets Respond Quickly source: Gurkaynak, Sack, and Swanson (2005)

10. Event Study Approach

11. Event Study Dates

12. Hypothesis Tests H 0 : Operation Twist announcements had no effect on Treasury yields H 1 : A decrease in net supply of long-term bonds: Decreases long-term interest rates May raise short-term interest rates Does not lower short-term interest rates (Federal Reserve targets short-term interest rates)

13. Results

14. Comparison to the Literature Modigliani-Sutch (1966) Gagnon et al. (2010) D’Amico-King (2010) Hamilton-Wu (2010) Greenwood-Vayanos (2008) Krishnamurthy- Vissing-Jorgensen (2007) Warnock-Warnock (2009) < 20bp 14 to 30 bp 100 bp 17 bp 10 to 16 bp N/A (6 to 16 bp) N/A (76 bp) Predicted effect of QE2 on long-term yields Study

15. Comparison to a Funds Rate Surprise source: Gurkaynak, Sack, and Swanson (2005)

16. Results: Agency and Corporate Bond Yields

17. Small Response of Corporate Bond Yields Two main interpretations of this finding: Moody’s Aaa and Baa indexes are illiquid, slow to respond Corporate bonds are not very good substitutes for Treasuries Caveats of the illiquidity-based explanation: Quoted bond yields are functions of dealer bids & offers Serial correlation of Moody’s Aaa and Baa indexes in 1962 are -.07 and -.10, respectively, inconsistent with under-response Krishnamurthy and Vissing-Jorgensen (2011) find the same phenomenon for QE2

18. Three Myths Operation Twist was different from QE2 Operation Twist was small Operation Twist had essentially no effect

19. Conclusions Operation Twist was remarkably similar to QE2 High-frequency event-study analysis: Operation Twist had highly statistically significant effect on Treasury yields But the effect was moderate, about 15bp Consistent with lower end of range of estimates of Treasury supply effects in the literature Effects of Operation Twist diminish as one moves away from Treasuries toward private credit markets

20. Markets in Fall 2008 Are Not Representative source: Gurkaynak and Wright (2011)

21. Event Study Analysis of QE1 Is Problematic

22. Theoretical Motivation Tobin (1958): “Portfolio Balance” model Modigliani and Sutch (1966): “Preferred Habitat” model Idea: Heterogeneous investors have different preferred habitats Arbitrage is limited (risk aversion, capital constraints) Decreasing supply of a security raises its price (reduces risk premium) More recently: Greenwood and Vayanos (2008), Vayanos and Vila (2009)