What is Operation Twist, the Federal Reserve's latest move to boost the economy?
Mechanically speaking, the Federal Reserve intends to purchase, by the end of June 2012, $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.
The Federal Reserve's Goal
One of the functions of the Federal Reserve is to influence the borrowing rate of the U.S. economy.
Usually, they just control short-term interest rates by setting the federal funds rate. After the global financial crisis, however, they have enacted unconventional measures to influence longer-term interest rates.
They started buying long-term Treasuries in the open markets, which drags down their yields (interest rates) and the entire borrowing rate for that maturity in the U.S. economy.
These purchases were called quantitative easing (QE). The Fed, so far, has conducted two rounds of them: QE1 and QE2.
Now, with Operation Twist, the Fed's goal is to again influence longer-term yields.
More QE? Not Quite
If the Fed is purchasing Treasuries with the goal of influencing longer-term interest rates, isn't it just quantitative easing?
In QE1 and QE2, the Federal Reserve, through its purchases, injected fresh money into the financial system and took Treasuries out of the financial system.
The net effect was lower yields across the board.
In Operation Twist, the Federal Reserve is offsetting its purchases of longer-term Treasuries by selling its holdings of shorter-term Treasuries.
In net terms, no new cash will be injected. The total value of outstanding Treasuries outside of the Fed's balance sheet of all maturities will not be decreased.
Impact of Operation Twist
Whereas the impact of QE1 and QE2 was lower interest rates across all maturities, the impact of Operation Twist is this:
1) Lower interest rates for longer-term maturities (6 years to 30 years) than it otherwise would have been
2) Higher interest rates for shorter-term maturities (3 years or less) than it otherwise would have been
The Fed's hope is that pushing up shorter-term interest rates won't matter because they're already ultra-low whereas pushing down long-term interest rates will help because they're comparatively higher.
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