October 5, 2011

Operation Twist: Is the Fed Offering Solutions or Empty Gestures?

QE2, the Fed’s $600 billion Treasury purchase in 2010, was expected to stimulate the economy by getting banks lending again, reduce the risk of deflation, and decrease unemployment. But its real effect on the struggling economy has been minimal at best.

As acknowledged by the Federal Reserve’s Federal Open Market Committee, there is a “continuing weakness in overall labor market conditions, and the unemployment rate remains elevated.” So much for QE2.

Now the Fed has a new plan—dubbed “Operation Twist”—and this one will cost $400 billion.

In response to continued slow economic growth, the Federal Reserve announced last week that it plans to purchase “$400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less” by the end of June 2012. In other words, the Fed will be selling $400 billion worth of shorter-term Treasury securities and using the proceeds from those sales to purchase longer-term Treasury securities. 

The FOMC expects this program to “put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.” The Fed purchase is intended to raise the demand for Treasuries, which should decrease the Treasury yield curve—allowing the government to pay back only the bonds’ face value plus the interest rate.

Although the primary desired effect of Operation Twist is to increase short-term interest rates and decrease long-term rates, the Fed also hopes to increase investment in corporate bonds and other fixed-income securities. While this could potentially translate into continued low interest rates and even encourage job creation, it’s unlikely to have any real effect on the sour economy.

“We expect the Fed’s actions to have very little visible effect on the economy, because the level of interest rates and the shape of the curve are not the key constraints on growth,” according to an economist writing in the Wall Street Journal.

To make matters worse, the U.S. Treasury is working at cross purposes with the Fed. At the same time as the Fed launched Operation Twist, the Treasury is hoping to decrease the country’s reliance on short-term debt by selling more long-term Treasuries. That will increase the supply of long-term Treasuries, directly opposing the Fed’s efforts.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’sSummit Business Media partner, AdvisorFX, for a free trial.

You may also be interested in signing up for a free trial with another Summit Business Media partner, Tax Facts Online.

See also The Law Professor's blog at AdvisorFYI.

Reprints Discuss this story
This is where the comments go.