The Federal Reserve Does 'The Twist'

The Federal Reserve's much anticipated statement came yesterday after two days of FOMC meetings, the Fed's policymaking group. As expected, they decided to take new steps to try to boost the recovery, citing weakness in the housing sector and labor market, as well as the downside risks related to some instabilities in global financial markets. (To see the steps they have previously taken, see Stimulus.org).

The Fed's plan of action includes a couple of different policies. The centerpiece is that they will be lengthening the average maturity of the Treasury securities that they currently hold by buying $400 billion of 6 to 30-year bonds and selling an equal amount of short-term Treasuries (which is what they traditionally hold to conduct open market operations). This is a reprise of a move the Fed did in the early 1960s, which was referred to as "Operation Twist." The intent, like previous bond-buying, is to lower long-term interest rates enough to try to push people out of the bond market and into long-term investments, including business investments and mortgages for consumers.

Second, they will be re-investing the proceeds of maturing agency debt and mortgage-backed securities back into mortgage-backed securities. Previous, the Fed had allowed their holdings of MBSs to decline, since they were re-investing these proceeds into long-term Treasuries. Now, they will aim to keep their holdings of MBSs relatively constant (while continuing to re-invest the proceeds from long-term Treasuries back into Treasuries).

In addition, the Fed continued to promise to keep interest rates at their current low levels through at least mid-2013.

Unlike the previous QEs, this move would not actually increase the size of the balance sheet, but rather change its allocation to focus more on the parts of the economy they feel need it. It is almost the monetary equivalent of "more bang for the buck." The Fed's holdings of mortgage-backed securities have declined by about $250 billion since their peak in June of last year, but housing prices have remained very low, so they have decided to instead keep their holdings constant. Also, yields on ten-year bonds are at record-low levels (a full percentage point below where they were at the start of QE2), so the Fed wants to reverse the flight-to-quality that has been occurring lately.