Operation Twist: Here We Go Again!

In its FOMC minutes released yesterday, the Fed finally revealed its plans and forecasts for Uncle Sam. What exactly did the central bank have to say? More importantly, how did markets react?

Fed does the Twist…Again

One of the most important part (if not THE most important) part of the Fed’s announcements was its decision to extend the Operation Twist program until December this year. If you remember, Operation Twist is the Fed’s way of exchanging short-term securities for longer-term ones. The desired effect is to bring down long-term interest rates, making it easier for businesses and households to borrow money.

Last September the Fed announced that it would buy $400 billion worth of long-term securities until June this year. But now that the program is about to expire, the Fed has decided to extend it until December with another $267 billion worth of Treasury bonds and notes with maturities ranging from six to thirty years.

Growth, inflation, and unemployment forecasts

We can’t forget the other important details! Aside from announcing an extension for Operation Twist, the Fed also kept rates on hold at 0.0% to 0.25%.

In addition to that, the central bank has also decided to lower its growth and inflation forecasts and raise its unemployment rate estimates.

The FOMC gang is now predicting 1.9% growth in 2012, a downgrade from its 2.4% estimate last April. Unemployment prospects were also bumped up as the central bankers now see the rate at 8.0% to 8.2% by the end of the year. Again, this is a downward revision from the 7.8% to 8.0% forecasts last April.

The Fed isn’t too worried about inflation though, as they expect the core inflation rate to come in at 1.2% to 1.7% this year compared to its 1.9% to 2.0% forecast last April.

As many of you have probably guessed, it was the deterioration in economic data that had bothered the Fed members. Not only was unemployment picking up quickly, but indicators on housing, manufacturing, and consumer and investor confidence have also taken big hits in the past couple of weeks. Of course, it didn’t help that concerns in the euro debt crisis escalated to new heights as well.

Price Action

EUR/USD Chart

Interestingly, we saw the dollar rally at the release of the statement. I suspect that the markets were eager to hear more forceful action from the Fed, and weren’t quite pleased with just an expansion of the Operation Twist program. This sent EUR/USD sharply lower to 1.2640.

However, the sentiment was short lived as German Chancellor Angela Merkel dropped some comments about the “possibility” of bond purchasing via the European rescue funds. In any case, this helped EUR/USD recover and soon the pair found itself trading back above the 1.2700 handle.

What’s in store for the Fed?

Looking ahead, we should keep in mind that the Fed appears to have changed its stance back in April, when it was quite optimistic about the economy. Now, Fed President Ben Bernanke has acknowledged weakness in the economy, and that the central bank is a lot more open to further action in order to stimulate economic growth and prop up the labor market. He even said that the Fed has a few tricks up its sleeve to get the job done!

You know what this means right? The possibility of QE3 is becoming more and more real!

For now, we’ll have to keep an eye on economic data, specifically on jobs reports, as this is what many Fed officials are tracking. If the labor market continues to deteriorate, then additional quantitative easing measures may be a foregone conclusion.

As for the dollar, implementation of more easing measures may prove to be a double whammy for the Greenback. Not only would this make the dollar “fundamentally” weaker, but it could also boost risk appetite, which would cause even more weakness in the dollar as people move their funds to higher yielding assets.