Operation Twist redux

There is growing talk that the Fed is going to try a tactical change in operating procedures to further lower interest rates and boost the economy. There seems to be little the Fed can do to lower rates in the front-end of the yield curve. Rates are already close to zero. The short-end of the curve is in a liquidity trap and monetary policy is not providing any new support for more lending. The Fed has tried announcing policy goals through stating last month that rates will be kept low through mid-2013. It is not clear that this will work. A quantitative action may have benefit and this type of policy will not chnage the balance sheet of the Fed. The composition will change but not the size.

The new qunatitative policy may go back to the old playbook of Operation Twist from the 1960's whereby the Fed will swap some of their intermediate and short-term holdings of Treasuries for longer-term bonds. The purchase of long-term in exchange for shorter-term is supposed to flatten the yield curve and make the cost of borrowing lower. The impact of Operation Twist in the 1960's was unclear. Long rates should be a reflection of the weighted average of forward short-term rates and not the supply of debt. Nevertheless, the rally of long bonds is associated with the expectation that this is a possible policy that will not change the Fed balance sheet but will have an impact on rates. This could be wishful thinking but right now the market wants to hold long bonds.