Operation Twist extension won't aid US economy: BofA ML

All eyes are on the outcome of the FOMC meeting later tonight as Chairman Ben Bernanke is expected to expand Operation Twist to boost growth and buy protection against a deeper crisis in Europe. The Fed is also likely to keep rates unchanged.

However, Ethan Harris, BofA ML Global Research is not very positive about the outcome. According to him, Operation Twist will not aid economy much.  In an interview to CNBC-TV18, he said, "Operation Twist is too small a policy to really make sense. At the end of this year we are going to have a very big potential fiscal tightening and the Fed needs a policy that will address not just the current weakness in the economy, but also likely weakness at year end. I think that makes the case for a bigger policy." Harris believes that the Fed is likely to announce an asset buying programme of between USD 500-800 billion in August or September meeting. "That is better designed to deal with the scale of the challenge to US than a small twist program that will help the economy for only a couple of months," he adds. He also stresses that the Fed needs to expand balance sheet and increase asset purchases. Below is an edited transcript of his interview with Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying video. Q: What is your expectation from the FOMC later? Is it going to be an extension of Operation Twist or a clear promise of some kind of QE? A: Our view is that there is about one in three chance that we get a new asset buying program out of the Fed. We think it’s much likely however that they go ahead with very dovish language, hint that they are likely to move in the future but not actually introduce a new program. We don’t think the data has been weak enough to convince the Fed that they need to move yet. Q: So does it look like we will get just an extension of Operation Twist which has been in play or do you think you will actually get a bit more than that in terms of some hint on new asset purchases? A: I think Operation Twist is too small a policy to really make sense. The US faces some pretty big challenges ahead. At the end of this year we are going to have a very big potential fiscal tightening and the Fed needs a policy that will address not just the current weakness in the economy, but also likely weakness at year end. I think that makes the case for a bigger policy. We think that in either August or September meeting the Fed will announce an asset buying program of between USD 500-800 billion that’s better designed to deal with the scale of the challenge to US than a small twist program that will help the economy for only a couple of months. Q: If the Fed does not ease right now, do you expect the kind of recent weak spell of economic data to worsen over the next few weeks? A: I think the Fed looks at the recent data and they think that at least some of this is a payback for very strong data in the winter. We had a very mild winter in the United States and this encouraged a lot of businesses to pull forward activity, to hire people earlier than they would have normally. That meant that the spring season was weaker than normal, so there was a bit of a payback for that very strong winter data. We think the Fed is now waiting for a couple of more months to confirm that the slowdown here is not just due to these weather related effects, but really is more fundamental. The economy is hurting because of Europe and the economy is facing a big challenge around its own fiscal policy. So yes, we do expect the Fed to wait a bit longer, but we think by the time we get into August or September the Fed will have a pretty strong case and at that point we think they will go ahead and do a new easing policy. Q: What is it that you expect to hear from the EU Summit next week? Expectations were raised that once Greece was out the system maybe there would be more aggressive policy action. A: What I would like to see from the Europeans is much more decisive policy. The whole crisis has been a series of half measures that only come after the markets are in severe distress, so it’s really a very bad dynamic here. I think you are going to get more the same next week where they announce some further steps towards fiscal and banking support, but don’t really offer a serious package. They still don’t have the political will to do the kind of bailout that Spain needs right now. So unfortunately I think the crisis probably has to get a little worse before we get decisive action out of European policymakers. Q: So any core expectations then from the ECB at their policy meet in July? A: I think that they are hoping that they can get the fiscal authorities to move first, but ultimately when push comes to shove, if things get dangerous enough in the markets and the economy, the ECB will act first. We think by July the ECB will be cutting rates. We expect two 25 basis points cuts before year end. Hopefully that will come with fiscal actions as well, but the ECB can’t sit and play a waiting game forever. Somebody has to act and prevent a meltdown in Europe, so it could well be that the ECB ends up acting before fiscal authorities act. Q: There was a lot of talk last week about coordinated central bank easing ahead of the Greek elections. Now that that event is out of the way, do you see the prospect of such kind of coordinated easing which might lead to a fillip in risk assets in the near-term? A: I think we have to remember that the scope for doing coordinated policy is pretty limited right now. Clearly central banks can continue to ease as they deal with a much weaker economy and we will see continued easing. We will see quantitative easing from the Fed, we will see interest rate cuts across emerging markets, but the coordination part is a bit hard to envision unless the crisis is really looking awful. They are each on a different time schedule in terms of dealing with their own economies and coordinated intervention doesn’t save Europe. It saves the global system from a severe financial crisis. But Europe has to fix their own problems; the coordinated part really is dealing with collateral damage from Europe. So I think the hopes around coordinated policy are little overdone. There is no magic bullet out there; Europe just has to get moving in terms of fiscal policy.