Untwisting Operation Twist

The Federal Reserve Bank’s announcement yesterday(September 21, 2011) that Operation Twist will be implemented is getting much attention. Operation Twist originated in 1961 under the Kennedy administration and is named for the popular dance craze of the day. The “twist” is the exchange of reserves from shorter term to longer term bonds and the effect on short-term and long-term interest rates.rnOperation Twist is meant to improve the economic climate by lowering interest rates on long-term borrowing. The plan is to have the Fed buy $400 billion of long-term bonds 6 to 30 years maturity) and pay for them by selling short-term bonds (3-5 years maturity or less).rnThe interest rate change is predicted because when the Fed buys a lot of long-term bonds the price of those bonds rises. Although the purchase price of a bond rises, the payoff remains the same. The bond’s yield is reduced by lowering the difference between the purchase price and the future value of the bond at maturity.rnLower long-term bond yields mean less interest is paid to get long-term money. This should translate into lower interest rates for long-term borrowing in general, including home mortgage interest rates. It is the Fed’s hope that lower rates will stimulate the economy and avoid a “double-dip” recession that is being mentioned by many experts lately.rnAccording to thestreet.com http://www.thestreet.com/story/10992472/1/FEDs-no-1-in-treasury-holdings-report.html in an article of Feb. 2011 the Fed owned over a trillion dollars of bonds. Selling some and buying others is a realistic method. Alternatively, the Fed maygo out and print new money and use the new money to buy long-term government bonds. This could also raises the bonds’ prices, lower their yields, and provide a helpful boost to growth. Selling short-term bonds to buy long-term bonds Operation Twist is regarded as a lower risk of inflation than printing money to inject into the economy.rnIn our next post we will discuss potential benefits and disadvantages of the twist.