Doing the Twist, and other Fed tools

September 16, 2011

For markets, it’s a fait accompli: the Federal Reserve, which meets on Tuesday and Wednesday, is expected to push for some variation on a 1961 policy, known as Operation Twist because it aims to push down long-term borrowing costs while nudging short-term rates higher. Primary dealer banks polled by Reuters two weeks ago, just after the Labor Department reported the U.S. job market had stagnated in August, saw an 80 percent chance that some of sort of twist-like measure would be put into place.

Still, there are a number of variants the Fed could employ:

Half Twist: The most modest, perhaps too weak given market fragility, would be to direct proceeds from existing bonds on the balance sheet into longer-dated Treasury securities.

Full Twist: A more aggressive approach would involve active sales of short-dated bills and longer bond buys, and attempt to flatten the yield curve to effectively force investors to take more risk by lending at longer maturities. A February paper from the San Francisco Fed argued that, unlike the conventional wisdom that the original Operation Twist was a failure, the measure actually drove down long term Treasury yields by what the study calls a “highly statistically significant” 0.15 percentage point.

QE3-Lite: In order to overcome the objections of the Fed’s inflation hawks to a further expansion of the $2.9 trillion balance sheet, officials could choose to “sterilize” any new bond purchases by conducting open market operations such as reverse repos to drain reserves even as it injects temporary liquidity. This option might be thought of as QE3-lite.

QE3: A fresh bond purchase program, a full QE3, is not seen as on the table for now, but remains an option if growth fails to pick up. The second round of bond buying implemented late last year prompted heavy criticism from conservative economists and emerging market policymakers.

Communications: The Fed in August took the unprecedented step of vowing to keep interest rates low until 2013, although three officials dissented against the move while others wanted to take bolder steps immediately. The Fed could extend this guarantee to the balance sheet, or tie policy to specific goals for unemployment and inflation, a controversial step that was debated at the Fed’s August meeting.

IOER: The Fed could lower the 0.25 percent interest rate it currently pays banks on excess reserves held at the Fed. Doing so could encourage banks to put those reserves to use by lending them out. But Bernanke has said the likely impact of moving this already low rate even lower would be marginal, and there are worries about the impact the measure might have on money market funds.

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