Why an MBS-Treasury swap is better policy than the Treasury twist

Annette Vissing-Jørgensen and I wrote the short policy brief below. This afternoon, it was discussed in the Real Time Economics blog of the Wall Street Journal.

Why an MBS-Treasury swap is better policy than the Treasury twist

Arvind Krishnamurthy and Annette Vissing-Jørgensen

July 24, 2012

Policy note in PDF version

This note compares the effect of an MBS-Treasury swap (a strategy of purchasing long-maturity agency MBS and selling long-maturity Treasury bonds) versus the Treasury twist (purchasing long-maturity Treasury bonds and selling short-maturity ones).

We make two main points:

1. Purchasing long MBS brings down long MBS yields by more than would an equal sized purchase of long Treasury bonds and thus is likely to create a larger stimulus to economic activity via a larger reduction in homeowner borrowing costs
2. Purchasing Treasury bonds brings down Treasury yields, but part of this decrease indicates a welfare cost rather than a benefit to the economy. Thus it would be better to sell rather than purchase long-term Treasury bonds.

These points lead us to conclude that a superior large-scale asset purchase policy for the Fed is an MBS-Treasury swap where the Fed purchases long-maturity MBS, financed by a sale of long-maturity Treasury bonds.

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The US debt deluge

The warning tremors that might presage a major US fiscal crisis began today.  A major credit rating agency, Moody’s, wrote of the current US fiscal projections: “If such a trajectory were to materialize, there would at some point be downward pressure on the triple A rating of the federal government.”

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A Stimulus Plan for China

The Chinese economy is slowing rapidly. The latest estimates show declines of several percent in official Chinese growth rates, which might be indicative of an actual recession. The Chinese government, like many around the world, is responding with a large economic stimulus plan. Official estimates are that the plan will cost roughly 14 percent of one year of China’s GDP, or well more than double the relative size of the proposed plan in the U.S. While some of the proposed stimulus spending may be worth doing anyway, the idea of a stimulus plan is to spend and build more than is worth doing in an economic slowdown. In the rush to stimulate the economy, there will surely be some waste and investments undertaken that in retrospect may be worthless.

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