Operation Twist: Is It Enough?

After days of suspense, the Fed finally revealed its short-term plans for the economy. Get ready U.S.A., Operation Twist is officially on! Duhnduhnduhn!

If you remember, the Fed’s “Operation Twist” got its name from a similar program conducted with the Treasury Department back in the early 1960’s, named after Chubby Checker’s hit song, “The Twist.”

What exactly is Operation Twist?

Basically, since the Fed’s short-term interest rates are already at rock bottom, the bank now plans to stimulate borrowing by dragging down the yields of long-term interest rates. The Fed plans to do this by shifting its assets around.

The Fed will sell 400 billion USD worth of short-term Treasury securities and invest the proceeds to its long-term securities by June 2012. Not only that, the Fed also plans to take the proceeds from its maturing mortgage-backed securities (MBS) and reinvest them in other MBS. The move is a divergence from the Fed’s earlier decision to reinvest MBS proceeds into Treasury bonds, a practice that reduces the Fed’s mortgage-related assets.

Another important nugget from the FOMC statement is the Fed’s decision to downgrade its economic outlook. It said that “there are significant downside risks to the economic outlook, including strains in global financial markets.” Recall that the central bank’s August statement had no discussion of the global markets despite the brouhaha going on in the euro zone.

Operation Twist

Almost as soon as the FOMC statement was released, risk aversion swept the markets and boosted the dollar across the board. The Greenback even hit monthly highs against the pound and the euro! Aside from the dollar’s safe haven reputation though, it might have also helped that the Fed fell short of the market’s dreaded expectations. You see, market junkies were expecting the Fed to talk about adopting measures that would have bolder effects on the economy.

Right now many are skeptical if Operation Twist would give the economy its much-needed boost. Analysts did the math and estimated that the Fed’s move would only add 0.2% to 0.4% to next year’s GDP. They pointed out that many of the U.S. economy‘s problems don’t even rely on interest rates (think consumer and business confidence).

Operation Twist also has its risks to the economy. The Fed could end up sustaining losses if inflation rises since mortgage bonds and long-term Treasury bonds are more volatile than short-term bonds. Even banks are threatened by the move as banks usually profit from the difference between short-term and long-term interest rates.

With all the skepticism surrounding it, I guess it’s safe to conclude that Operation Twist is not really the best move out there to twist and turn the economy around towards the path of recovery. However, we also have to give the Fed some credit for coming up with something. I mean, it’s better than not doing anything, right?