Friday, September 30, 2011

The Fed Cannot Force Investors to Shift to a Different Risk-Return Profile.

Operation Twist may reduce not increase economic growth

This posting expands on concepts introduced in “Speak Softly But Carry a Big Stick, Dr. Bernanke” and “Operation Twist, Or Is It the Logic That’s Twisted?” However, it is self-contained as a discussion of the application of Modern Portfolio Theory to the issue of Operation Twist. It is a response to the WALL STREET JOURNAL, September 30, 2011 article entitled: “Fed's Twist May Prompt Bigger Turn.” The article is well worth reading if one doesn’t understand how bond investors manage average duration. However, it overlooks how people manage overall portfolio risk.

Macroeconomics needs to thoroughly incorporate the thinking behind the shift from adaptive expectation to rational expectation. The rational response to the twisting of the yield curve is to barbell one’s portfolio. The average duration can be retained by managing the cash to long bond balance. It is the only hope for those who want to maintain a given risk / return profile. This was mentioned on the blog in “Speak Softly But Carry a Big Stick, Dr. Bernanke.”

The effect on the economy surfaces through holding cash reserves rather than productive capital investment. Liquidity trap is what economists call it when people hoard their cash. Operation twist contributes to the very problem a central bank can’t easily solve (i.e., a liquidity trap).

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